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Profit-Sharing Plans: How Do They Work?

If you’re employed by a small business, you may be able to benefit from profit-sharing plans.

With a profit-sharing plan, businesses help their employees save for retirement by making contributions based on the company’s performance during the past year.  

For employees, having the ability to take advantage of a profit-sharing plan is a major benefit.

And if you’re a small business owner, profit-sharing plans can be a great tool for talent recruitment and retention.

How Do Profit-Sharing Plans Work?

Unlike some other retirement plans, like 401(k) plans, the employee doesn’t make any contributions to a profit-sharing plan.

Instead, all contributions come from the employer

The business decides how much to contribute to employees’ accounts each year, and the contributions are completely discretionary.

Contributions can vary

The amounts can fluctuate from year to year and, if your business’ needs change, you can even decide to contribute nothing.

There’s no guarantee that employees will continue to see contributions from a profit-sharing plan. 

For example, if your business had an incredible year and exceeded revenue expectations in 2019, you could opt to deposit 25% of each employee’s compensation into their profit-sharing plan account.

But if the business struggled in 2020 and you didn’t meet your targets, you could make a smaller contribution, or decide to contribute nothing at all. 

Contribution limits

Profit-sharing plans are subject to contribution limits set by the IRS. The per-employee annual limit is the lesser of:

  • 25% of the employee’s compensation
  • $57,000 for 2020

Employers need to take care not to discriminate against certain groups of employees.

To ensure that they treat employees equally, businesses usually choose to follow one of two options:

1. Flat percentage for all employees

A company may decide that all employees will receive a percentage of their compensation as a contribution to the profit-sharing plan.

For instance, an employer may decide to contribute 10% of their employees’ salaries. For an employee who earns $40,000 per year, the contribution would be $4,000.

For an employee who earns $200,000 per year, the contribution would be $20,000.

2. Flat dollar amount for all employees

Instead of a percentage, a company can decide to offer the same amount to all employees, regardless of their seniority or salary.

For example, they may decide to contribute $5,000 to each employee’s account.

Which Employees Are Eligible?

A profit-sharing plan must be available to all employees, not just senior-level managers.

However, businesses can decide to exclude certain employees:

  • Employees under the age of 21
  • Employees who have completed less than two years of service
  • Employees that are covered by a collective bargaining agreement that does not provide for plan participation or if retirement benefits were the subject of good faith bargaining
  • Certain nonresident aliens

What is the Vesting Schedule?

The company that is participating in the profit-sharing plan decides the vesting schedule; it can vary from business to business.

Some companies opt for their profit-sharing plans to be fully vested when they’re made, meaning the employee has complete access to the entire amount right away.

Others set their profit-sharing plans on a vesting schedule, where employees gain access to a tiered percentage of the plan based on their years of service

If you decide as a business to limit profit-sharing plans to employees who have worked for the company for at least two years, the plan must be completely vested.

How Are Taxes Handled By the Employer?

Contributions made to profit-sharing plans are tax-deductible for your business.

For employees who benefit from these plans, they offer tax-deferred growth potential. 

Contributions to the profit-sharing plan must be made by the employer’s tax filing deadline.

Each year, the employer must file Form 5500-Reports of Employee Benefit Plan with the IRS.

Taxes

If an employee who is under the age of 59½ decides to take a withdrawal from the profit-sharing plan, the distributions may be subject to income tax and a 10 percent early withdrawal penalty.

In some cases:

Employees can avoid the penalty if they are over the age of 55 and end their employment with the company. 

For business owners, minimum required distributions start at age 70½.

For employees, they can wait until retirement age (if they decide to retire after 70½). 

When it comes time for distributions, profit-sharing plans typically offer the following options:

  1. Lump-sum distribution of the account
  2. Roll over the account to an IRA or another employer’s retirement plan
  3. Periodic distributions

Benefits of Profit-Sharing Plans

To offer profit-sharing plans, businesses need to work with service providers, which often charge hefty service fees.

But while profit-sharing plans can have higher administrative costs than some other retirement plans and incentive programs, they can be well worth the expense. 

An incentive to perform

Offering a profit-sharing plan is a great way to supplement your company’s retirement plans and incentivize employees.

In fact:

Having a profit-sharing plan is a big selling feature in recruiting new talent, and can help you retain top employees year after year.

And, unlike other benefits, which require a cost commitment, profit-sharing plans give you flexibility. You can scale the profit-sharing plan up or down depending on your business’ performance. 

Because contributions to profit-sharing plans are dependent on the business’ performance, employees are more likely to feel invested in the company’s success and will be more willing to go above and beyond to help the business succeed.

Help boost retirement savings

And, your contributions to profit-sharing plans are tax-deductible. 

Plus, employees get to bolster their retirement savings, without having to set aside their own money.

With so much of the American population having too little saved for retirement — the U.S. Government Accountability Office reported that approximately half of households headed by someone aged 55 or older had no retirement savings at all —  that’s a significant benefit.

Compared to 401(k) Plans

You shouldn’t think of profit-sharing plans as a replacement for a traditional retirement plan like a 401(k).

Instead, they’re more of a supplement.

While they have some similarities, they differ from one another in several key ways.

Contributions

While an employer may contribute to an employee's 401(k) plan — often called the employer match — the employee is primarily responsible for making contributions to the 401(k) plan.

With a profit-sharing plan, only the employer makes contributions.

Contribution limits

As of 2020, the contribution limit for 401(k) plans is $19,500 for employees.

Profit-sharing plans have much higher limits; the employer can contribute up to 25 percent of the employee’s compensation or $57,000, whichever is less.

Types of employers

Both large and small companies offer 401(k) plans.

By contrast, profit-sharing plans are usually limited to smaller companies with 100 employees or less.

Saving for Retirement

Profit-sharing plans are an excellent perk offered by some employers that can bolster your retirement savings.

While the amounts can fluctuate from year to year, contributions come solely from the employer, and can be an excellent supplement to your other retirement savings plans. 

For more information, here’s what you should know about how to start saving for retirement.