Profit-sharing plans: What to know

While there are many types of retirement plans, a profit-sharing plan is one in which business owners can share profits with employees. But how does this type of plan work, and how much could an employee get?

Below is some information to help you understand how profit-sharing plans work and how they might affect how you plan for retirement.

Key takeaways

• A profit-sharing plan is one in which an employer makes contributions, based on company profits, to employees’ retirement funds.
• Employers may contribute up to 25% of the company’s total payroll to a profit-sharing plan.
• For 2023, the contribution limit for an individual’s account is either 100% of the employee’s compensation or $66,000—whichever is less.
• Companies may change the amount they contribute from year to year but must have a set formula for how funds are divided.

A profit-sharing plan is a type of retirement plan in which employers can contribute a portion of the company’s money to their employees. Contributions are typically tied to a company’s profits. But according to the IRS, a “business does not need profits to make contributions to a profit-sharing plan.”

With profit-sharing plans, eligible employees have accounts in which funds are deposited. Profit-sharing funds may be added as a bonus contribution to an employee’s 401(k) or into a separate account.

Profit-sharing plans are entirely funded by employer contributions. That means employees don’t have to make contributions to benefit from the profit-sharing plan.

If an employer decides to run a profit-sharing plan, they can decide how much to contribute to the plan each year—even if that contribution is $0. But the employer must have a set formula for how they distribute funds among employees.

Employers may use a vesting schedule to determine when an employee can access funds earmarked for them in the profit-sharing plan. This means that the employee might only access the funds after working at the company for a set period.

Employees are able to begin making withdrawals from the retirement account of a profit-sharing plan after age 59 1/2. If an employee withdraws funds before that age, they can be subject to a 10% penalty on the amount they withdraw.

Employers can contribute up to 25% of the company’s total payroll under a profit-sharing plan. There’s also a contribution limit at the individual employee level—100% of the employee’s total compensation or $66,000 for 2023, whichever is less.

If an employer offers a profit-sharing plan, it’s often available for most employees. But the IRS lists the following conditions that may prevent an employee from being eligible:

• Being under 21
• Working for the company for less than a year
• Participating in a collective bargaining agreement, like a union
• Having a nonresident alien status

The SECURE 2.0 Act of 2022 may also affect eligibility if the profit-sharing plan is tied to another retirement plan.

The IRS says that employers must have a set formula to determine how company funds are distributed through a profit-sharing plan. But the company can make the plan “as simple or as complex” as it wants.

Common types of profit-sharing plans include:

• Comp-to-comp plan: The employer divides an employee’s compensation by the company’s total compensation to find the employee’s percentage. Then, the employer can apply that percentage to the total profit-sharing contribution to get the employee’s amount.
• Pro-rata plan: The employer contributes the same amount to each employee, either as a fixed amount or percentage of profits.
• Age-weighted plan: Employers can choose to give a larger percentage of a contribution to employees who are older. This provides older employees with more funds as they approach retirement.
• New comparability plan: An employer may set different rates for how they contribute to groups of employees. For example, there might be a higher contribution rate for company leaders. But even with this type of plan, there must be enough contributions for all employees so that nondiscrimination rules are followed.

Profit-sharing plans are a type of retirement plan. They might have things in common with other retirement plans, like a 401(k), traditional IRA or SEP IRA. But ultimately, each is different. Talking to an expert about retirement planning can help you understand how they all work—and might work together.

A profit-sharing plan allows employers to contribute company funds toward employees’ retirement. These funds may go into an employee’s stand-alone retirement account or be added as a bonus contribution to a 401(k) plan. While employers aren’t required to contribute every year to the profit-sharing plan, they have to follow a nondiscriminatory formula that benefits all employees. Employees don’t need to contribute in order to receive benefits from a profit-sharing plan.

To learn more about retirement planning, check out this guide on how to save for retirement.