What Is a Profit-Sharing Plan?
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 great way for a business to give its employees a sense of ownership in the company, but there are typically restrictions as towhen and how a person can withdraw these funds without penalties.
Key Takeaways
- A profit-sharing plan gives employees a share in their company’s profits based on its quarterly or annual earnings.
- It is up to the company to decide how much of its profits it wishes to share.
- Contributions to a profit-sharing plan are made by the company only; employees cannot make them, too.
Understanding Profit-Sharing Plans
So how does profit sharing work? Well, to start, a profit-sharing plan is any retirement plan that accepts discretionary employer contributions. This means a retirement plan with employee contributions, such as a 401(k) or something similar, is not a profit-sharing plan, because of the personal contributions.
Because employers set up profit-sharing plans, businesses decidehow much they want to allocate to each employee. A company that offers a profit-sharing plan adjusts it as needed, sometimes making zero contributions in some years. In the years when it makes contributions, however, the company must come up with a set formula for profit allocation.
The most common way for a business to determine the allocation of a profit-sharing plan is through the comp-to-comp method. Using this calculation, an employer first calculates the sum total of all of its employees’ compensation. Then, to determine what percentage of the profit-sharing plan, an employee is entitled to, the company divides each employee’s annual compensation by that total. To arrive at the amount due to the employee, that percentage is multiplied by the amount of total profits being shared.
The most frequently used formula for a company to determine a profit-sharing allocation is called the “comp-to-comp method.”
Example of a Profit-Sharing Plan
Let’s assume a business with only two employees uses a comp-to-comp method for profit sharing. In this case, employee A earns $50,000 a year, and employee B earns $100,000 a year. If the business owner shares 10%of the annual profits and the business earns $100,000 in a fiscal year, the company would allocate profit shareas 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
$61,000
The contribution limit for a company sharing profits with an employee for 2022 and $67,500 including catch-up contributions for those 50 or over during the year.
Requirements for a Profit-Sharing Plan
A profit-sharing plan is available for a business of any size, and a company can establish one even if it already has other retirement plans. Further, a company has a lot of flexibility in how it can implement a profit-sharing plan. As with a 401(k) plan, an employer has full discretion over how and when it makes contributions. However, all companies have to prove that a profit-sharing plan does not discriminate in favor of highly compensated employees.
As of 2022, the contribution limit for a company sharing its profits may not exceed the lesser of 100% of your compensation or $61,000. This limit increases to $67,500 for 2022if you include catch-up contributions. In addition, the amount of an employee’s salary that can be considered for a profit-sharing plan is limited, in 2022 to $305,000.
To implement a profit-sharing plan, all businesses must fill out an Internal Revenue Service Form 5500 and disclose all participants of the plan. Early withdrawals, just as with other retirement plans, are subject to penalties, though with certain exceptions.
Is a Profit-Sharing Plan the Same As a 401(k)?
No, a profit-sharing plan is not the same thing as a 401(k). With a profit-sharing plan, a company gives employees a portion of the profit based on quarterly or annual earnings. With a 401(k), employees are making personal contributions. In some cases, a company will partially match an employee's 401(k) contribution.
What Are the Different Types of Profit-Sharing Plans?
With a cash plan, employees are given either cash or stock on a regular basis, such as quarterly or annually. The payouts are quick, relative to a retirement plan, but they are also taxed as regular income. A deferred plan sees profits set aside for a later date, usually when the employee retires. The employee is also not taxed until retirement. Some plans combine elements of both a cash and a deferred plan.
How Do Employers Determine Contribution Amounts to a Profit-Sharing Plan?
Employers typically use one of two methods to determine contribution amounts. With a comp-to-comp method, the total amount of compensation given to all employees is calculated. Next, each employee's compensation is divided by the total compensation, yielding a percentage that establishes each employee's portion of the profit. The higher an employee's salary, the greater the percentage of the profits that the person receives. Less commonly, a company may give the same percentage of profits to every employee, regardless of that employee's salary.
The Bottom Line
A profit-sharing plan is a way for employers to provide employees with a portion of the business's profits, based on quarterly or annual earnings. Contributions are given out on a regular basis, or are put into a fund that is made available at a later time, such as when the employee retires.
A profit-sharing plan is funded entirely by the employer, and is therefore different from a 401(k), which is primarily funded by the employee. Profit-sharing plans are generally seen as a meaningful way to motivate employees, by directly connecting the company's success to the employees' increased compensation.
