What Is a Profit-Sharing Plan?

Profit-Sharing Plans Explained in Less Than 5 Minutes

Female employee seated at desk looking up at her employer

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A profit-sharing plan is a type of defined contribution plan that allows companies to help their employees save for retirement. Employers use these plans to give their workers a stake in the company's success. It's also a benefit that can be used to attract new hires.

Learn how profit-sharing plans work, who is eligible for these plans, and what your share of profits might be if your employer chooses to participate.

Definitions and Examples of Profit-Sharing Plans

Profit-sharing plans are a way for a company to share profits with its workers. Contributions from the company are discretionary. The company can decide how much it will put into the plan from year to year. It can even decide not to contribute at all.

This flexibility makes it a nice option for both small and larger businesses. A profit-sharing plan aligns the financial well-being of workers with the company's success.

A company doesn't have to make contributions to a profit-sharing plan if it doesn't make a profit. But, it doesn't have to be profitable in order to provide workers with this type of plan.

Unlike 401(k) plan participants, workers with profit-sharing plans don't make their own contributions. A company can offer other types of retirement plans, such as a 401(k), along with a profit-sharing plan.

A company can legally exclude certain employees from the plan. These include nonresident aliens, those who are younger than age 21, and those who are covered by collective bargaining agreements that don't provide for participation. Employees with a short tenure can also be excluded. This depends on the plan.

Employees who are age 21 or older cannot be excluded because of age.

How a Profit-Sharing Plan Works

Employees can receive their shares of profits in the form of cash or company stock. Contributions are often made to a qualified tax-deferred retirement account. These accounts allow penalty-free distributions after age 59½. Some plans offer both deferred benefits and cash. The cash is taxed at ordinary income rates.

A combination of deferred benefits and cash acts like a retirement contribution plus a yearly bonus.

You can move assets from a profit-sharing plan into a rollover IRA if you leave your job. But you can be subject to a 10% tax penalty if you take a distribution before age 59½. A worker might be able to take a loan from their plan while still employed.

Profit-Sharing Plans vs. 401(k)s

A salary deferral feature added to a profit-sharing plan would define that plan as a 401(k). There are a few differences between the two.

Profit-Sharing Plans 401(k) Plans
A company contributes a percentage of its profits into an employee's plan. Employees also make contributions to their own plans.
A company's contributions are discretionary depending upon whether it's profitable.  Companies have the option of matching their employees' contributions.
Contributions don't match an employee's contributions.  

Benefits of Profit-Sharing Plans

Profit-sharing plans help workers save and plan for retirement. But, they're not without rewards for businesses, either. Happy workers tend to stay put for the long term. Plus, this type of plan can also entice new talent into signing on.

Requirements for Profit-Sharing Plans

There's no set amount that a company must put into its profit-sharing plan each year. But, there is a limit on the amount that can be made for each worker. This limit changes over time with inflation. The maximum contribution for a profit-sharing plan is the lesser of 25% of comp or $58,000 in 2021. 

There are also limits on the amount of your pay that goes into figuring out contributions. The limit is $290,000 as of 2021, an increase of $5,000 from 2019.

If the employer decides to make a contribution in a given year, it must follow a set formula. This formula says which workers get what and how much they receive.

How Will Your Employer Determine Your Share?

Many employers use the "comp-to-comp" method of figuring out how much you will get. With this method, your employer would add up its total comp spending for the year. Then, it would divide each employee's comp by the total. This is their share of the total pool.

For instance, let's say that your employer has a total comp budget of $1,000,000. They decide to create a profit-sharing pool of $100,000. Your yearly compensation is $50,000.

The formula to figure out your share would look like this:

Comp-to-comp profit-sharing formula

In other words, you would get 5% of the profit-sharing pool. Your share would be $5,000.

Other Requirements for Profit-Sharing Plans

Contributions can also vest over time, according to a set vesting schedule.

An employer must set up a system that tracks contributions, investments, and distributions. It must also file a yearly return with the government. These plans can require a good deal of administrative upkeep. But, many plan administrators will do this work on the firm's behalf.

Key Takeaways

  • A profit-sharing plan is similar to a 401(k) plan but more flexible.
  • A business does not have to make contributions to the plan in years that it’s not profitable.
  • Employees do not have to make their own contributions. Businesses with these plans are sharing any profits they've earned with their workers.
  • Workers can take profits in the form of cash or company stock. 

The Balance does not provide tax, investment, or financial services or advice. The information presented here is offered without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor, and it might not be suitable for all investors. Always consult with a professional if you're considering investing.