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What Is a Profit-Sharing Plan?

A profit-sharing plan is a form of Defined Contribution (DC) plan that relies on employer contributions to employees’ accounts. A business owner who wants to set up a profit-sharing plan for the benefit of herself and her employees may make generous contributions that are tax-deductible and enjoy tax-deferred growth. Does that sound too good to be true? It’s not.

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Profit-sharing plans can consist of either cash bonuses or contributions to tax-advantaged retirement accounts. For the purposes of this article, let’s focus on the retirement savings side of things. A profit-sharing plan is a bit like a 401(k), minus the deferred salary aspect. Take a 401(k), subtract the employee contributions and keep the company match and you’ve got a good idea of what a profit-sharing plan is.

Profit-Sharing Plans: The Basics

With a profit-sharing plan, an employer establishes and makes voluntary contributions to employees’ retirement accounts. These contributions can be made from the profits of the business (hence the name) and can be suspended at the discretion of the employer. The contributions and their earnings grow tax-deferred. Only when employees begin taking distributions in retirement does Uncle Sam take a cut.

Profit-Sharing Plan Rules

Employees do not contribute to profit-sharing plans. Instead, their employers establish, manage and fund the company retirement plan on their behalf. Because this process can be complicated and requires compliance with IRS rules and audits, most business owners choose to hire a third-party administrator.

Although employers may decide on a year-by-year basis whether to contribute to a profit-sharing plan for the company, their contributions must not discriminate against rank-and-file employees in favor of management. In other words, employers can skip a year or more of contributions, but they can’t skip specific employees. In fact, profit-sharing plans may be subject to non-discrimination audits.

Using a formula to calculate shared benefits helps a company avoid the appearance of discrimination. Some employers choose the simplest method and elect to contribute a set percentage of compensation to each employee’s account. Other employers choose the “comp-to-comp” method. With this method, an employer adds up all employee compensation. Then, for each employee, the employer divides that person’s compensation by the total company compensation to get a percentage. The employer then gives the employee that same percentage of the profits that are being shared.

Employee benefits in a profit-sharing plan are subject to IRS rules designed to discourage early withdrawal. As with a 401(k), employees who take distributions from their profit-sharing plan’s retirement account before age 59.5 will face a 10% penalty. Withdrawals will be taxed as income. The treatment of employee benefits if an employee leaves the company before retirement age varies from plan to plan. If you’re currently participating in a profit-sharing plan, it’s important to acquaint yourself with the details of its rules. Knowledge is power!

Profit-Sharing Plan Contribution Limits

The IRS sets annual limits for contributions to profit-sharing plans. For each employee, that limit is the lesser of either 100% of the participant’s compensation or, for 2020, $57,000 ($56,000 for 2019). Not bad, right? If you’re a business owner who is setting up a profit-sharing plan, this limit applies to you as well. Because these limits are much higher than with a traditional IRA, profit-sharing plans are a good option for older workers and business owners who need to make catch-up contributions in time for retirement.

Why Choose a Profit-Sharing Plan?

If you’re a business owner, establishing a profit-sharing plan can be a great way to boost your own retirement savings and the savings of your employees. You can have a profit-sharing plan and another retirement plan, too. Think of a profit-sharing plan as a supplement to the 401(k), not a replacement. You’ll still likely want to offer a 401(k) to encourage employees to take part in building their own retirement savings with pre-tax dollars.

A business of any size can establish a profit-sharing plan. A generous plan can help you attract and retain talent and you’ll still have the flexibility to ease up on contributions in lean years. You can also make contributions in years when you don’t turn a profit if you’d like. Although it’s called a profit-sharing plan, there is no rule that says your contributions have to come from profit.

One of the biggest benefits of profit-sharing plans is that they can motivate employees. So, although profit-sharing plans have higher administrative costs than SEP IRAs or SIMPLE IRAs, the very name of a profit-sharing plan can get workers fired up about increasing company profits. There’s a simple explanation: if employees know they’re getting bonuses, either in cash or as contributions to a retirement account, they’ll likely feel that they have more of a stake in the success of the company. And that’s good news for you and your bottom line.

Tips for Getting Retirement Ready

  • Figure out how much you’ll need to save in order to retire comfortably. An easy way to get ahead on saving for retirement is by taking advantage of employer 401(k) matching.
  • Work with a financial advisor. According to industry experts, people who work with a financial advisor are twice as likely to be on track to meet their retirement goals. A matching tool like SmartAsset’s SmartAdvisor can help you find a person to work with to meet your needs. First you’ll answer a series of questions about your situation and goals. Then the program will narrow down your options from thousands of advisors to up to three registered investment advisors who suit your needs. You can then read their profiles to learn more about them, interview them on the phone or in person and choose who to work with in the future. This allows you to find a good fit while the program does much of the hard work for you.

Photo credit: flickr

Amelia Josephson Amelia Josephson is a writer passionate about covering financial literacy topics. Her areas of expertise include retirement and home buying. Amelia's work has appeared across the web, including on AOL, CBS News and The Simple Dollar. She holds degrees from Columbia and Oxford. Originally from Alaska, Amelia now calls Brooklyn home.
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