What is profit-sharing?
A profit-sharing plan is a retirement plan that allows an employer or company owner to share the profits in the business, up to 25 percent of the company’s payroll, with the firm’s employees. The employer can decide how much to set aside each year, and any size employer can use the plan.
The benefit to employees is that they could accumulate more than in a typical 401(k) plan. And for 2023 workers can receive up to a whopping $66,000 total or 100 percent of compensation, whichever is less, in employer-sponsored accounts. In addition, a $6,500 catch-up contribution may also be made by those age 50 or over in that tax year.
Here’s how a profit-sharing plan works, a comparison of the different kinds of plans available and the benefits of using these plans to reward employees.
How does profit-sharing work?
A profit-sharing plan is one of many different kinds of retirement plans offering employers a way to provide a benefit to employees. The plan can provide a lot of flexibility in how money can be distributed, though employers must abide by certain rules in how they administer the plan, in order to avoid discrimination.
For employees, that means they need to do nothing to participate in the plan or max out its benefits. The profit-sharing is, in effect, a bonus on top of any other retirement benefits.
The plan can be operated as a separate account or it can be a feature added to a 401(k) account, but either way it’s only the employer making contributions through the profit-sharing feature.
As a qualified retirement plan, the funds can be withdrawn without penalty after the employee turns 59 1/2, though withdrawals before that age are subject to a 10 percent penalty on top of any taxes owed. Withdrawal rules are similar to those for a traditional IRA, and participants will have required minimum withdrawals when they reach age 73.
From sole proprietors to large corporations, a company of any size can participate in the plan. Employers may decide how much to share with employees, up to 25 percent of their payroll during that tax year. The maximum amount of salary that can be used to figure the profit-sharing bonus is limited to $330,000 in 2023.
Employers are not obligated to use the program from year to year, allowing them to shut off the plan, if needed or desired. However, when the employer does make contributions, they must be made according to a predetermined formula, to ensure that the profits are divided legally.
Employers have flexibility in how benefits are distributed. Plans are tested annually to ensure that benefits are not being offered in a way that discriminates against employees, such as lower-level workers vis-a-vis managers and owners.
Like some other retirement plans, employers can require the funds to vest, meaning that employees must continue working at the company for a period of time before fully owning the funds. But once the employee owns the funds, they cannot be clawed back by the employer.
Types of profit-sharing plans
Profit-sharing plans come in a few varieties, but they’re all still fundamentally based on the employer providing money to the employee. The differences in these varieties involve how benefits are shared with employees, and the distribution schemes include:
- Pro-rata plan – In this setup, everyone involved in the plan receives the same contribution from the employer. This could be a fixed dollar amount or percentage of salary.
- Age-weighted plan – Under this plan, employers can consider how the profit-sharing would affect the employee’s retirement, taking age and salary into consideration. The net effect is that employers can offer older workers a higher percentage contribution than younger workers, because they have fewer years to retirement.
- New comparability plan – In this plan, also called a cross-testing plan, the employer can contribute to different employee groups at different rates. This plan helps the employer reward different employee groups (including an owner) with various benefits, even if they have similar ages.
A pro-rata plan is the most standard choice, though it may be too rigid for many employers. The head of the company may receive 15 or 20 percent of compensation as part of the plan, meaning the lower-paid administrative staff must receive the same percentage.
“As a pure employee benefit, this works great, but most employers are not looking to give to everyone at the same levels,” says Mark Wilson, president of MILE Wealth Management in Irvine, California.
And that’s where the other plan types come in. An age-weighted plan allows the employer to provide higher benefits to older employees and to do so legally, within certain limits.
The new comparability plan offers a lot of flexibility for employers or owners who want to retain the most for themselves even while offering employees a benefit. It also gives them a way to contribute to employees at various rates based on criteria that are important to the employer.
“For employers, they need to be strategic about the levels of employees they determine for their plan,” says Tatiana Tsoir, CEO of Linza Advisors in Mount Kisco, New York. Employers are able to favor “highly compensated employees by setting them up in a different group,” says Tsoir.
That flexibility offers employers the opportunity to fine-tune their benefits.
“For example, a new comp plan might give 10 percent to the legal staff and 5 percent to the administrative staff,” says Wilson. “In the right circ*mstances, these plans can work out very well.”
Such new comparability plans are limited in the differential they can offer employees, however. They must offer all employees at least either 5 percent of pay or one-third of what the most highly compensated employee receives under the plan.
Benefits of using a profit-sharing plan
For employees, the benefit is obvious – it allows them to save more. But these profit-sharing payments aren’t subject to Social Security and Medicare taxes, so the net benefits are even larger to employees than a comparable taxable bonus. A profit-sharing plan may offer quite a few benefits to employers, too, especially relative to other retirement plans.
First, a profit-sharing plan may motivate employees to be more productive. If they understand that their work translates into a higher reward, they may think more like owners of the business.
It may also help attract and retain skilled employees, and the adept use of a vesting schedule may help encourage the talent to stick around longer.
Tax advantages
Employers also derive tax benefits from the profit-sharing plan. Contributions to a 401(k) with profit sharing are tax deductible, reducing the employer’s tax liability. Tsoir says that employers can decide as late as September of the next year and still get a deduction for the prior tax year.
While profit-sharing plans do require some annual testing and reporting requirements, they also “allow for vesting schedules, loan provisions, and different eligibility rules that are often better than plans like a SEP IRA,” says Wilson.
Advantages over other plans
A SEP IRA, another popular retirement plan option among smaller businesses, may be easier to set up and administer, but it requires the business to pay the same retirement benefit to all employees, offering little flexibility. It also lacks the ability to require vesting, a feature that may help employees remain with the employer longer.
Similarly, a SIMPLE IRA offers an easier way to set up a retirement plan with reduced reporting requirements. It too offers less flexibility in employer contributions and does not offer vesting. Also important to note, the amount an employee contributes to a SIMPLE IRA from their salary cannot exceed $15,000 in 2023. Those age 50 and older are permitted to make up to another $3,500 in catch-up contributions.
So, a profit-sharing plan can offer some notable advantages over other plans, and it can be set up as an add-on to a 401(k), making that plan the key hub for an employee’s retirement savings.
Bottom line
A profit-sharing plan offers employers a lot of flexibility when they decide to offer this benefit to employees, unlike some other retirement plans. Not only can employers turn off the benefit, if they need or want to, but they’re also able to more finely tune the benefits structure to reward certain employees more, even while taking a tax break for providing the benefits.
FAQs
A profit-sharing plan is a defined contribution retirement plan that gives employees a share of the profits of their company. A profit-sharing contribution is not tied to an employee's contribution to a retirement plan.
How does a profit-sharing plan work? ›
A profit-sharing plan is a retirement plan that allows an employer or company owner to share the profits in the business, up to 25 percent of the company's payroll, with the firm's employees. The employer can decide how much to set aside each year, and any size employer can use the plan.
What are the 3 types of profit-sharing? ›
There are three basic types of profit sharing plans: traditional, age-weighted and new comparability.
What is a disadvantage of a profit-sharing plan? ›
The disadvantage of profit sharing plans is that they are discretionary, meaning employer contributions are not mandatory or guaranteed. The administration costs for a profit sharing plan are also higher than those for standard retirement plans.
What is a typical profit-sharing plan percentage? ›
There's no required profit-sharing percentage, but experts recommend staying between 2.5% and 7.5%.
Do I get my profit-sharing if you quit? ›
If you leave your job, you cannot take the profit-sharing money with you. However, you may be able to roll over the money into an IRA or another retirement plan.
Can you withdraw money from a profit-sharing plan? ›
Typically: You cannot withdraw money in a profit sharing plan before age 59 1/2 without a 10% early withdrawal penalty. But administrators of a profit sharing plan have more flexibility in deciding when a worker can make a penalty-free withdrawal than they would with a traditional 401(k).
Is profit-sharing better than 401k? ›
Adding a profit-sharing contribution allows the company to make larger contributions to an employee's retirement plan account when compared to a 401(k) plan, which is limited by caps on employee elective deferrals.
What is a 3% profit-sharing plan? ›
For example, if the profit sharing percentage is 3%, the employer will make a 3% contribution based on each eligible employee's salary.
How is profit-sharing calculated? ›
To determine each employee's allocation of the employer's contribution, you divide the employee's compensation (employee "comp") by the total comp. You then multiply each employee's fraction by the amount of the employer contribution. Using this method will get you each employee's share of the employer contribution.
Profit Sharing vs Equity
The key difference between the two is that equity sharing is a better option for startups that need capital right away to get going. Profit sharing, however, is a better option for established businesses that are trying to attract and retain new employees.
Why choose a profit-sharing plan? ›
Profit sharing helps create a culture of ownership.
When employees are rewarded based on their contributions to the company's success, employees feel like owners. As owners, employees have more incentive to increase the company's profitability.
Under what conditions are profit-sharing plans not likely to motivate employees? ›
While profit sharing done right can help motivate employees, there are also some drawbacks. For example, if your small business is a startup that isn't yet profitable, your employees may never see any benefits from the system you have created. Thus, they may feel profit sharing is meaningless as a benefit.
How much is a good profit-sharing bonus? ›
What is Profit Sharing? One very basic type of bonus program is current profit sharing. A company sets aside a predetermined amount; a typical bonus percentage would be 2.5 and 7.5 percent of payroll but sometimes as high as 15 percent, as a bonus on top of base salary.
What is the rule of 55 for profit-sharing plans? ›
The rule of 55 is an IRS provision that allows workers who leave their job for any reason to start taking penalty-free distributions from their current employer's retirement plan once they've reached age 55.
Is 4% profit good? ›
The profit margin for small businesses depend on the size and nature of the business. But in general, a healthy profit margin for a small business tends to range anywhere between 7% to 10%. Keep in mind, though, that certain businesses may see lower margins, such as retail or food-related companies.
Is profit-sharing just a bonus? ›
Profit sharing is an incentivized compensation program that awards employees a percentage of the company's profits. The amount awarded is based on the company's earnings over a set period of time, usually once a year. Unlike employee bonuses, profit sharing is only applied when the company sees a profit.
How long to be vested in profit-sharing? ›
The Internal Revenue Code (IRC) provides two acceptable vesting schedules 401(k) and profit sharing plans: three-year cliff and two- to six-year graded.
Is profit-sharing taxed like a bonus? ›
Current profit-sharing plan: it is paid in cash or stocks and it is paid whenever it is assigned. It provides instant gratification. However, the total amount is taxable as regular income.
What happens to a profit-sharing plan when the owner dies? ›
In the case of an individual who has died, if there is no successor Trustee of the profit sharing plan expressly named or someone named to continue to run the business, it is likely that a court will have to act to name a successor Trustee of the profit sharing plan.
The 401(k) profit sharing component is popular with the self-employed who have a Solo 401(k) plan. With a Solo 401(k) plan you are both the employer and employee and can contribute up to $61,000 in 2022 into your 401(k). Yes, that can drop your taxable income big time, maybe even a tax bracket.
What is an example of profit-sharing? ›
Example of a Profit-Sharing Plan
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 share as follows: Employee A = ($100,000 X 0.10) X ($50,000 / $150,000), or $3,333.33.
Where does profit-sharing money go? ›
Under profit-sharing, only the employer contributes to the retirement account. The employer establishes a uniform rule for how they contribute money to all employees' retirement accounts. Then they receive a tax deduction for these contributions.
Is profit-sharing reported on w2? ›
Form W-2, Box 13
You should check the retirement plan box if an employee was an "active participant" for any part of the year in: a qualified pension, profit-sharing, or stock-bonus plan under Internal Revenue Code Section 401(a) (including a 401(k) plan).
How do I report profit-sharing on my taxes? ›
IRS Form 1099-R
Employees use the form to identify the taxable amount of distributions, such as those from cash profit-sharing plans or those made prior to retirement. Businesses must file the 1099-R for each year that distributions are made to employees from profit-sharing plans.
What can I roll my profit-sharing plan into? ›
Key Takeaways
- You can roll over a profit-sharing plan into a SEP IRA without taxes being withheld if the IRS guidelines are followed. ...
- A trustee-to-trustee transfer can rollover the funds, which are sent directly from the plan administrator to the institution holding the SEP.
The most common eligibility requirement used by employers is that an employee must be with the company at least one full year, as a full-time employee, to qualify. This allows the company to benefit from the employee's productivity before paying part of the company profits as a bonus.
Is profit-sharing better than salary? ›
Benefits of profit sharing
Employees who work for businesses with profit-sharing plans in place often earn more than their fixed wages. They may also save for retirement much faster than with a typical 401(k) plan.
Is profit-sharing good for employees? ›
Profit-sharing plans may help strengthen employee loyalty, encourage teams to work toward shared goals, and increase productivity and efficiency.
What is the 25% rule for profit-sharing? ›
If you, the employer, make contributions to a profit sharing plan, you can deduct up to 25 percent of the compensation paid during the taxable year to all participants. Your contributions to the plan can either be fully vested (nonforfeitable) when made, or they can vest over time according to a vesting schedule.
What is Profit Sharing? Unlike equity compensation, profit sharing isn't tied in any way to an ownership stake in the business. But because a company can choose to tie profit sharing to business performance, profit-sharing plans incentivize and reward behaviors that help the company succeed and grow.
Why is profit-sharing taxed so high? ›
Why are bonuses are taxed so high? Bonuses are taxed heavily because of what's called "supplemental income." Although all of your earned dollars are equal at tax time, when bonuses are issued, they're considered supplemental income by the IRS and held to a higher withholding rate.
Which is best profit share? ›
High Profit stocks
| S.No. | Name | CMP Rs. |
|---|
| 1. | Premier | 2.30 |
| 2. | PAE | 5.33 |
| 3. | Mipco Seaml Ring | 11.61 |
| 4. | Starlite Comp. | 2.14 |
23 more rowsA profit-sharing program is exactly as it sounds: Your company gives employees a percentage of its quarterly or annual earnings. It's typically based on your organization's profit, which is your total revenue minus total expenses.
What are the two different types of profit-sharing plans? ›
Many employers offer a profit-sharing plan in addition to traditional 401(k)s. There are different types of profit-sharing plans you can use to incentivize and reward your employees. These plans fall into two types: deferred or cash.
Who can be excluded from profit-sharing plan? ›
Let's get started. A profit-sharing plan is very flexible. You can exclude employees who work less than 1,000 hours per year; exclude employees who are under age 21, use vesting to reward longer-term employees, allow participant loans, and provide lump-sum distributions.
Why profit-sharing doesn t work? ›
One of the problems with revenue sharing is that you can't earn a consistent, predictable income. This is because you won't know whether or not there will be a profit from week to week, month to month or for the year, until after the fact. Even if you know your business will be profitable, you won't know by how much.
What does it mean to be vested in a profit-sharing plan? ›
“Vesting” in a retirement plan means ownership. This means that each employee will vest, or own, a certain percentage of their account in the plan each year. An employee who is 100% vested in his or her account balance owns 100% of it and the employer cannot forfeit, or take it back, for any reason.
What percentage of profit should be your salary? ›
Payroll to Revenue Ratio Frequently Asked Questions
The rule of thumb is that between 15% to 30% of your gross sales should go to payroll.
Is 20% a good profit? ›
You may be asking yourself, “what is a good profit margin?” A good margin will vary considerably by industry, but as a general rule of thumb, a 10% net profit margin is considered average, a 20% margin is considered high (or “good”), and a 5% margin is low.
The 10% rule encourages you to save at least 10% of your income before taxes and expenses. Calculating the 10% savings rule is a simple equation: divide your gross earnings by 10. The money you save can help build a retirement account, establish an emergency fund, or go toward a down payment on a mortgage.
How do you calculate profit-sharing? ›
To calculate, divide each employee's salary by the total salary pool to determine their percentage, then multiply this figure by the total profit sharing allocation to determine contribution amounts.
Is profit-sharing the same as a bonus? ›
Profit sharing is an incentivized compensation program that awards employees a percentage of the company's profits. The amount awarded is based on the company's earnings over a set period of time, usually once a year. Unlike employee bonuses, profit sharing is only applied when the company sees a profit.
What does 4% profit-sharing mean? ›
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.
Is profit sharing good for employees? ›
Profit-sharing plans may help strengthen employee loyalty, encourage teams to work toward shared goals, and increase productivity and efficiency.
Where does profit sharing money go? ›
Under profit-sharing, only the employer contributes to the retirement account. The employer establishes a uniform rule for how they contribute money to all employees' retirement accounts. Then they receive a tax deduction for these contributions.
Does profit sharing go into 401k? ›
The 401(k) profit sharing component is popular with the self-employed who have a Solo 401(k) plan. With a Solo 401(k) plan you are both the employer and employee and can contribute up to $61,000 in 2022 into your 401(k). Yes, that can drop your taxable income big time, maybe even a tax bracket.
Is profit sharing considered earned income? ›
Take the annual amount, divide by 12, and count the result as earned income each month. In most situations, profit sharing is earned income. It is included in the gross earnings when received. The client receives the Earned Income Disregard.
What are the advantages of profit sharing plans? ›
Common profit-sharing advantages
- Higher productivity. A profit-sharing plan directly links an employee's labour with the company profits and, in doing so, incentivise employees to work harder. ...
- Higher earning potential. ...
- Cordial relations. ...
- Reduced labour turnover. ...
- Reduced unemployment. ...
- Sense of ownership. ...
- Deferred. ...
- Direct cash.
The most common eligibility requirement used by employers is that an employee must be with the company at least one full year, as a full-time employee, to qualify. This allows the company to benefit from the employee's productivity before paying part of the company profits as a bonus.
