What Is a Profit-Sharing Plan?

Definition and Examples of a Profit-Sharing Plan

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 help their employees save for retirement. Contributions from the company are discretionary. The company can decide how much it will contribute from year to year, or even if it will contribute at all to an employee's plan.

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

What Is a Profit-Sharing Plan?

A company doesn't have to make contributions to a profit-sharing plan if it doesn't make a profit, but it doesn't necessarily have to be profitable in order to provide employees with a profit-sharing plan.

Unlike 401(k) plan participants, employees 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, including nonresident aliens, those who are younger than age 21, and those who covered by collective bargaining agreements that don't provide for participation. Employees who have worked for their companies for less than one or two years can also be excluded, depending 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 typically made to a qualified tax-deferred retirement account that allows penalty-free distributions that can be taken after age 59½. Some plans offer a combination of deferred benefits and cash, with cash being distributed and taxed at ordinary income rates.

A combination of deferred benefits and cash acts something like a retirement contribution plus an annual bonus.

You can move assets from a profit-sharing plan into a rollover IRA if you leave the company, but you can be subject to a 10% tax penalty if you take a distribution instead before age 59½.  An employee might be able to take a loan from a profit-sharing 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 some subtle differences between the two.

Profit-Sharing Plans 401(k) Plans
A company contributes a percentage of its profits into an employee's qualified retirement 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 obviously benefit employees by helping them save and plan for retirement, but they're not without rewards for businesses, either. Happy employees tend to remain employees for the long term, and offering a profit-sharing plan can also entice new talent into signing on with the company.

Requirements for Profit-Sharing Plans

There's no set amount that a company must be contribute to its profit-sharing plan each year, but there is a maximum contribution amount that can be made for each employee. This limit fluctuates over time with inflation. The maximum contribution for a profit-sharing plan is the lesser of 25% of compensation or $57,000 in 2020, whichever is less. 

The amount of your compensation that can be taken into consideration when determining contributions is additionally limited. The compensation limitation is $285,000 as of 2020, an increase of $5,000 from 2019.

A company must follow a predetermined formula for deciding which employees get what and how much they receive if the employer decides to make a profit-sharing contribution in a given year. An employee's allocation is typically determined as a percentage of pay. 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, and must 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.

Key Takeaways

  • A profit-sharing plan is a type of defined contribution plan, 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 literally sharing any profits they've earned with their workers.
  • Employees 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.