What is profit sharing?
As the name indicates, profit sharing involves an employer giving employees some portion of the company’s quarterly or annual earnings. It’s up to the employer to decide exactly how much of the company profits to allocate for this type of plan, as well as how the money will be distributed—whether through cash bonuses or via contributions to a defined contribution plan.
If all of that sounds a little complicated, read on for a closer look at how profit-sharing plans operate and the benefits of this type of compensation.
How do profit-sharing plans work?
Profit-sharing plans are a type of retirement account that’s funded entirely by the employer or business owner. Employees do not make any contributions to this type of plan.
Furthermore, as the IRS explains, “there is no set amount that the law requires” an employer or business to contribute to such plans. “If you can afford to make some amount of contributions to the plan for a particular year, you can do so. Other years, you do not need to make contributions,” says the IRS website.
In fact, a business does not actually have to have profits to make contributions to a profit-sharing plan. Nor is the business required to give every employee the same amount of money through profit-sharing distributions.
However—and this is a key point—a business must establish a specific formula for deciding how contributions to a profit-sharing plan will be made. What’s more, businesses are not allowed to discriminate in favor of highly compensated employees through profit-sharing distributions.
And finally, as part of the structure of profit-sharing plans, the money provided to employees must go into a separate account for each employee. These accounts are tax-deferred retirement accounts.
Rules and regulations surrounding profit-sharing plans
A company’s size or type does not matter when it comes to establishing a profit-sharing plan. This type of compensation program can be established by companies small and large. Another important point, profit-sharing plans can be offered even in cases where a company already offers retirement programs like a 401(k). (More on that later).
And while it’s true that companies can decide how much to deposit into a profit sharing plan, there’s also an annual limit established by the IRS. For 2023, the limit is the lesser of 100 percent of an employee’s annual compensation, or $66,000.
An employer must also stipulate in writing how it will distribute contributions to employees. And companies may exclude employees from the plan who are 21 or younger or who have worked for the company for less than one year.
Finally, as an employee, it’s important to note that funds can be withdrawn from a profit-sharing plan at age 59½. Any money pulled from the plan before that age is subject to a 10 percent penalty.
Pros and cons of profit-sharing plans
For the business offering a profit-sharing plan, there can be both benefits and drawbacks to consider.
Flexible contributions: It’s entirely up to the business to decide how much or how little to contribute to a profit-sharing plan. The contributions are entirely discretionary, according to the IRS. This flexibility can be especially beneficial during years when a business’s cash flow has declined.
Can help attract and keep employees: Profit-sharing plans can be offered as part of an overall benefits package when hiring or recruiting new talent.
Inspires a culture of ownership: Providing employees with additional compensation based on the company’s success can help them to feel like owners, according to the national non-profit Edward Lowe Foundation. This can motivate employee performance, creativity, and loyalty.
- Administrative costs: The costs associated with maintaining a profit-sharing plan can be steeper than other more basic offerings, such as a Simplified Employee Pension (SEP) or Simple Individual Retirement Accounts (IRA) plans, according to the IRS.
- Regulations and documentation requirements: There are non-discrimination requirements associated with profit-sharing plans that must be tested annually. In addition, businesses must file a Form 5500-series report each year, according to the IRS.
What is profit-sharing vs a 401(k)
The primary distinction between a profit-sharing plan and a 401(k) plan is that the employee does not make any contributions to the profit sharing account. Instead, the employer funds the account.
A 401(k), on the other hand, typically involves deductions from an employee’s paycheck each pay period.
If you’re considering establishing a profit-sharing plan for your company, it can be helpful to meet with a qualified profit-sharing plan consultant to learn more about what’s involved. It’s also a good idea to outline your goals for the plan. In other words, are you creating a plan to attract and retain employees? To improve productivity? To compensate a small group of employees? Or everyone in the company? The answers to these questions will help guide the way your plan operates, should you decide to proceed and establish profit sharing.
And while you can certainly choose to manage a profit-sharing plan on your own, it can also be helpful to find a professional to administer the plan. This could include a mutual fund provider, an insurance company, or a financial institution such as a bank.
If you want to learn more about profit-sharing plans, the Department of Labor has created a helpful educational brochure covering how to establish and maintain these plans.