A profit-sharing plan is a retirement plan that gives employees a share in the profits of a company. Under this type of plan, also known as a deferred profit-sharing plan (DPSP), an employee receives a percentage of a company’s profits based on its quarterly or annual earnings. A profit-sharing plan is a wonderful way for a business to instill a sense of ownership among its employees, though restrictions often apply regarding when and how these funds can be accessed without penalties.
Key Takeaways
- A profit-sharing plan provides employees with a share of their company’s profits based on its quarterly or annual earnings.
- Companies have the flexibility to decide how much of their profits they wish to share.
- Contributions to a profit-sharing plan are made exclusively by the company; employees cannot contribute their own funds.
Understanding Profit-Sharing Plans
So how does profit sharing work? At its core, a profit-sharing plan is any retirement plan that involves discretionary employer contributions. This differentiates it from plans where employee contributions are mandatory, such as a 401(k).
Employers establish profit-sharing plans, deciding on the allocation for each employee. Companies can adjust these contributions, sometimes opting to make none in certain years. When contributions are made, there must be a predefined formula for allocating the shared profits.
A widely-used method for profit allocation is the comp-to-comp method. Using this calculation, an employer first computes the total compensation for all employees. To determine each employee’s share, the company divides each employee’s annual compensation by the total compensation, and then multiplies the resulting percentage by the total profits to be shared.
Example of a Profit-Sharing Plan
Let’s assume a business with two employees uses a comp-to-comp method for profit sharing. Employee A earns $50,000 a year, and Employee B earns $100,000 a year. If the business owner decides to share 10% of the annual profits and the business earns $100,000 in that year, the allocation is as follows:
- Employee A = ($100,000 X 0.10) X ($50,000 / $150,000), or $3,333.33
- Employee B = ($100,000 X 0.10) X ($100,000 / $150,000), or $6,666.67
Contribution Limits
The contribution limit for a company sharing profits with an employee for 2023 is $66,000, and increases to $73,500 for catch-up contributions for those aged 50 or over.
Requirements for a Profit-Sharing Plan
A profit-sharing plan is available for businesses of any size, and a company can implement one even if other retirement plans already exist. Employers have substantial flexibility in how and when contributions are made. However, companies must ensure that their profit-sharing plan is not biased in favor of highly compensated employees.
For 2023, the contribution limit for profit-sharing may not exceed the lesser of 100% of compensation or $66,000, with a limit increase to $73,500 including catch-up contributions. The maximum employee compensation that can be considered for allocation in 2023 is $330,000.
To establish a profit-sharing plan, businesses must complete an IRS Form 5500, detailing all plan participants. Early withdrawals may incur penalties, though exceptions are available under certain circumstances.
Is a Profit-Sharing Plan the Same As a 401(k)?
No, profit-sharing plans differ from 401(k) plans. Profit-sharing involves the distribution of company profits to employees based on performance. Conversely, 401(k) plans involve personal contributions by employees, often matched partially by the employer.
What Are the Different Types of Profit-Sharing Plans?
Profit-sharing plans can be structured in several ways:
- Cash Plans: Employees receive cash or stock regularly, such as annually or quarterly. While quickly accessible, these payments are taxed as regular income.
- Deferred Plans: Profits are set aside for future payout, generally at retirement, and not taxed until then.
- Combination Plans: Some plans blend elements of both cash and deferred plans.
How Do Employers Determine Contribution Amounts?
Employers may use the comp-to-comp method or provide a uniform percentage of profits across all employees, regardless of their salaries.
The Bottom Line
A profit-sharing plan provides employers with a strategic way to grant employees a share of business profits based on performance. Contributions are either given periodically or reserved for later disbursement, enhancing employee motivation by linking compensation to the company’s success. Profit-sharing plans are solely funded by employers, distinguishing them from employee-funded plans like 401(k)s.
Related Terms: 401(k), deferred profit-sharing plan, highly compensated employees.
References
- Internal Revenue Service. “Choosing a Retirement Plan: Profit-Sharing Plan”.
- Internal Revenue Service. “A Guide to Common Qualified Plan Requirements”.
- Internal Revenue Service. “Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits”.
- Internal Revenue Service. “Form 5500”,
- Internal Revenue Service. “Form 5500 Corner”.
- Internal Revenue Service. “Hardships, Early Withdrawals and Loans”.
