Takeaways
- Profit-sharing plans are retirement plans that give employees a portion of profits.
- Contributions are calculated based on a company's quarterly or annual profit.
- Employees can't contribute to a profit-sharing plan; only employers can.
- Contributions to profit-sharing plans grow tax-free until you make withdrawals.
- Employer contributions can fluctuate based on company performance and distribution formulas.
What Is a Profit-Sharing Plan?
A profit-sharing plan is a retirement plan offered by employers designed to give employees a share in the company's financial success. Unlike traditional retirement plans, such as pensions or 401(k) plans, a profit-sharing plan allows employers to contribute discretionary amounts based on the company's profits.
Importantly, employees cannot contribute to profit-sharing plans.[1] When the business does well, the employees benefit directly. Let's examine how profit-sharing plans work.
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How Profit-Sharing Plans Work
Profit-sharing plans are highly flexible retirement plans that companies offer employees. They are used as an incentive tool to attract and retain talented employees.
Companies decide how much to contribute to the profit-sharing plan each year based on company profits. Profit-sharing plans are unique because contributions are entirely discretionary, which means they are not mandatory. Your company is not obligated to contribute a fixed amount each year.
Employer contributions are typically allocated to employee accounts based on a predetermined formula. Standard formulas include allocating donations based on employee salary levels, tenure, or a combination.
One widely used method is the comp-to-comp method. The comp-to-comp method takes the total of each employee's compensation and distributes profits based on their percentage of compensation relative to the total compensation pool (more on this below).
Your employee account grows tax-deferred until it is withdrawn upon retirement or under exceptional circumstances allowed by the Internal Revenue Service (IRS).
Because contributions are flexible, an employer might contribute 5% of the company's profits to the profit-sharing plan in an exceptionally profitable year while contributing only 2% or even nothing in leaner times. As an employee, you benefit from the plan without needing to make contributions from your salary or bonus.
Annual Contribution Limits
| 2024 | 2025 | |
|---|---|---|
| Contribution Limit | Lesser of 100% of compensation or $69,000 | Lesser of 100% of compensation or $70,000 |
| Contribution Limit with Catch Up | $76,500 | $76,500 |
Source: Internal Revenue Service [2]
Example of Comp-to-Comp Method
Let's look at an example to better understand profit-sharing plans. Suppose a startup technology company implements a profit-sharing plan using the comp-to-comp method. The company has had a profitable year and has decided to contribute $500,000, or 10% of its $5,000,000 annual profit.
The firm then allocates these funds among its employees based on their salary level. Your salary of $125,000 makes up 10% of the company's total payroll. You would receive 5% of the allocated profit-sharing amount—in this case, $50,000.
Your employer contribution is then deposited into your profit-sharing account, which grows tax-free until retirement. You can keep your profit- accounts in your online brokerage account.
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Profit-Sharing Plan Requirements
Profit-sharing plans must meet specific guidelines set by the IRS. Here are some of the basic requirements:
- Written Plan: The plan must be documented in writing, clearly outlining how your contributions are determined and allocated.[3]
- Eligibility Criteria: Your employer must clearly define eligibility criteria. Companies are also responsible for notifying you about your eligibility. You will usually get notified when you start a new job, your company implements its first plan, or when you become eligible based on tenure.
- Non-discrimination Rules: Plans must benefit a broad base of employees and cannot disproportionately favor highly compensated employees or company executives. If your company uses the comp-to-comp method, you can earn more by ensuring you get the raise you deserve.
- Contribution Limits: For 2024, the IRS limits employer contributions to profit-sharing plans to the lesser of 100% of employee compensation or $69,000. Employees like profit-sharing plans because the contributions are much higher than 401(k) contribution limits.
- Vesting Schedules: Plans typically include vesting schedules, determining when employees fully own employer contributions. Typical vesting schedules range from immediate vesting to gradual vesting over several years, say 25% per year.
Companies can meet these requirements and keep their plan compliant. Profit-sharing plans give both employers and employees a chance to enjoy tax advantages.
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If you run a small business (say a freelancing business) or want to start your own company, consider starting a profit-sharing plan to attract highly talented employees.
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How Are Profit-Sharing Plans Taxed?
Profit-sharing plans offer tax benefits for employers and employees, making the plan super attractive. Here's how it works:
- Employer Contributions: Employer contributions are tax-deductible as a business expense, potentially reducing the company's taxable income. (Read about how this might affect Earnings Per Share).
- Employee Tax Benefits: Employees do not pay taxes on the contributed amounts or their earnings until withdrawal, typically during retirement. This allows investments to grow tax-deferred, significantly boosting the value of retirement savings. (Read about how to Retire 10 Years Early).
- Contribution Withdrawals: Once you withdraw money from your plan, it is treated as taxable income. Early withdrawals—before the age of 59½—generally trigger an additional 10% penalty from the IRS.
What Is a Good Profit-Sharing Percentage?
A good profit-sharing percentage depends on the company's profitability, financial stability, cash flow, industry standards, and long-term cash needs.
Company contributions to profit-sharing plans typically range between 3% and 10% of profits. However, percentages vary widely depending on industry benchmarks, company size, and business performance.
Here is how companies might decide their profit-sharing percentage:
- Industry Norms: Companies evaluate industry averages to stay competitive. Companies in highly profitable industries might offer higher percentages to attract and retain the best talent.
- Company Financial Health: One key consideration is whether a company is financially stable enough to offer a profit-sharing plan. A high contribution percentage could strain cash flow during less profitable years, while a percentage that is too low might fail to motivate employees.
- Employee Retention and Motivation: Higher percentages often boost employee morale, retention, and productivity. Your company might increase percentages during prosperous years to reward employee loyalty and contributions.
A good profit-sharing percentage truly balances employee incentives, motivation, and the company's ability to sustain contributions over the long term.
Smart Summary
Profit-sharing plans are retirement plans where only employers contribute to your retirement account from company profits. These plans offer a win-win scenario for employers and employees, providing tax benefits and retirement security and fostering a collaborative, motivated workforce. By aligning employee interests with company success, businesses can create an environment where everyone works toward shared financial goals.
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Frequently Asked Questions
You should absolutely participate in a profit-sharing plan. Your employer is giving you free retirement savings that you would otherwise not have. Unlike with 401(k) plans, where contributions are deducted from your compensation, you don’t need to consider triaging other aspects of your personal finances – like paying off debt or saving an emergency fund.
Where you invest contributions can be dependent on the plan. Some employers will give you an a la carte mix of investment options, such as index funds, exchange-traded funds, or mutual funds. Consider working with a financial advisor to map out your investments.
Yes. However, if you are under 59½, the IRS adds a 10% additional tax. Unfortunately, the IRS does not allow exceptions to this.
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(1) Internal Revenue Service. Choosing a retirement plan: Profit sharing plan. Last Accessed March 27, 2025.
(2) Internal Revenue Service. 401(k) limit increases to $23,500 for 2025, IRA limit remains $7,000. Last Accessed March 27, 2025.
(3) Internal Revenue Service. Profit Sharing Plans for Small Businesses. Last Accessed March 27, 2025.
