What Is a Profit Sharing Plan?
A profit sharing plan is a type of defined contribution plan that lets companies help employees save for retirement.
With this type of retirement plan, contributions from the employer are discretionary. That means the company can decide from year to year how much to contribute—or whether to contribute at all—to an employee's plan. If the company does not make a profit, it does not have to make contributions to the plan. (But a company does not need to be profitable to have a profit-sharing plan.)
This flexibility makes it a great retirement plan option for small businesses or businesses of any size. Plus, it aligns the financial well-being of employees to the company's success.
How a Profit Sharing Plan Works
Unlike 401(k) plan participants, employees with profit sharing plans do not make their own contributions. But a company can offer other types of retirement plans, such as a 401(k), along with a profit-sharing plan. In the event that a salary deferral feature is added to a profit-sharing plan, it would then be defined as a 401(k) plan.
Employees can get their profit shares in the form of cash or company stock. Typically, contributions are made to a qualified tax-deferred retirement account that allows penalty-free distributions to be taken after age 59 1/2. Some plans offer a combination of deferred benefits and cash, with cash being distributed and taxed directly at ordinary income rates—sort of like a retirement contribution plus an annual bonus.
If you leave the company, you can move assets from a profit sharing plan into a Rollover IRA, but distributions taken before age 59 1/2 may be subject to a 10% penalty. While still employed, an employee may be able to take a loan from a profit-sharing plan.
Profit Sharing Plan Maximum Contributions
While there is no set amount that must be contributed to a profit-sharing plan each year, there is a maximum contribution amount for each employee. The amount fluctuates over time with inflation. The maximum contribution amount for a profit sharing plan is the lesser of 25% of compensation or $57,000 in 2020.
Additionally, the amount of your compensation that can be taken into consideration when determining employer and employee contributions is limited. The compensation limitation is $285,000 in 2020.
Who Does What in a Profit Sharing Plan
Employees really don't have to do anything to benefit from this type of plan, but the company does have to do some calculations, planning, and paperwork.
If the employer does decide to make a profit-sharing contribution in a given year, the company must follow a predetermined formula for deciding which employees get what and how much. An employee's allocation is typically determined as a percentage of pay. Contributions can also vest over time, according to a set vesting schedule.
The employer must also set up a system that tracks contributions, investments, distributions, and more, and file an annual return with the government. These plans can require a good deal of administrative upkeep, but many plan administrators will do this work on the company's behalf.
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IRS. ”Choosing a Retirement Plan: Profit-Sharing Plan.” Accessed Feb. 7, 2020.
Department of Labor. ”FAQs About Retirement Plans and ERISA,” Page 9. Accessed Feb. 7, 2020.
IRS. “Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits.” Accessed Feb. 7, 2020.
IRS. “Profit Sharing Plans for Small Businesses.” Accessed Feb. 7, 2020.