What Is a Profit Sharing Plan?
A profit sharing plan is a type of defined contribution plan that allows employers to contribute a portion of their company's profits to their employees' retirement planning accounts. These plans fall under the broader category of employee benefits, offering a flexible way for businesses to share their financial success with their workforce. Unlike other retirement plans that may require fixed contributions, a profit sharing plan grants the employer discretion over whether to contribute each year and the amount of the contribution, typically based on profitability or other predetermined criteria. This flexibility can be particularly appealing to businesses whose financial performance may fluctuate. The funds contributed to a profit sharing plan are allocated to individual participant accounts and grow tax-deferred until withdrawal in retirement.
History and Origin
The concept of sharing profits with employees has roots in the late 19th and early 20th centuries, often as a means to boost employee morale, productivity, and loyalty. However, the modern framework for profit sharing plans, particularly their tax-advantaged status, largely emerged with significant legislative developments in the United States. A pivotal moment for these plans, alongside other employer-sponsored retirement programs, was the passage of the Revenue Act of 1942. This act established the foundational tax-qualified requirements for retirement plans, including profit sharing plans, allowing employer contributions and plan earnings to grow tax-deferred for employees, and providing tax deductions for employers.7 This incentivized companies to offer such plans as a valuable component of their compensation strategies.
Key Takeaways
- A profit sharing plan is a type of defined contribution retirement plan funded by employer contributions.
- Contributions are typically discretionary and often tied to the company's profitability or other business metrics.
- Employee accounts grow tax-deferred, and distributions are taxed upon withdrawal in retirement.
- These plans offer flexibility for employers, allowing them to adjust contributions based on financial performance.
- Participants gain a vested interest in the company's success, which can align employee and employer goals.
Interpreting the Profit Sharing Plan
A profit sharing plan typically involves the employer making employer contributions to individual employee accounts based on a formula outlined in the plan document. This formula often ties the allocation to an employee's compensation, allowing higher-earning employees to receive a larger share of the total contribution, though other allocation methods exist. The value an employee receives from a profit sharing plan depends on several factors: the amount the employer contributes each year, the investment performance of the funds within the employee's account, and the vesting schedule of the plan. A vesting schedule dictates when an employee gains full ownership of the employer's contributions; if an employee leaves before being fully vested, they may forfeit a portion of the employer's contributions.
Hypothetical Example
Consider "InnovateTech Solutions," a growing software company. For the fiscal year, after a period of strong company performance, the management decides to contribute 10% of its pre-tax profits to its profit sharing plan, totaling $200,000. The plan document specifies a "comp-to-comp" allocation method, meaning each employee receives a share proportional to their annual salary relative to the total eligible payroll.
Suppose John, a software engineer, earns $100,000 annually, and the total eligible payroll for all employees participating in the plan is $2,000,000.
John's share of the profit sharing pool would be calculated as:
John's Allocation = (John's Salary / Total Eligible Payroll) Total Company Contribution
John's Allocation = ($100,000 / $2,000,000) $200,000
John's Allocation = 0.05 $200,000
John's Allocation = $10,000
This $10,000 is then deposited into John's individual participant accounts within the plan, where it can be invested and grow tax-deferred alongside any other funds in his account.
Practical Applications
Profit sharing plans serve as significant tools in corporate financial planning and human resources, offering multiple benefits to both employers and employees. For employers, these plans provide tax advantages as contributions are typically tax-deductible6, reducing a company's taxable income. They also offer a flexible means of incentivizing employees, as the amount contributed can be adjusted based on the company's financial health, rather than being a fixed obligation.
From an employee perspective, profit sharing plans allow for tax-deferred growth of retirement savings, supplementing other forms of compensation. The funds within a profit sharing plan are typically invested in a diversified investment portfolio chosen by the participant from a selection offered by the plan. These plans are governed by the Employee Retirement Income Security Act of 1974 (ERISA), which sets minimum standards for most voluntarily established retirement plans in the private sector to protect participants.5 This includes rules regarding participation, vesting, funding, and fiduciary duty.4
Limitations and Criticisms
Despite their advantages, profit sharing plans have certain limitations. The primary criticism centers on the discretionary nature of employer contributions. While flexibility is a benefit for the employer, it means that contributions are not guaranteed and can vary significantly from year to year, or even be zero if the company does not perform well or chooses not to contribute.2, 3 This variability can create uncertainty for employees regarding their future retirement savings. Unlike a fixed contribution plan, employees cannot rely on a consistent annual contribution, which can impact their long-term retirement planning and expectations.
For businesses, especially small ones, profit sharing contributions represent business expenses that, while flexible, must still be managed. While an employer can choose not to contribute in a given year, consistently low or absent contributions may diminish the plan's effectiveness as an incentive or retention tool. Furthermore, managing a qualified plan like a profit sharing plan involves administrative complexities and compliance requirements under ERISA, which can be burdensome for some businesses.1
Profit Sharing Plan vs. 401(k) Plan
Profit sharing plans and 401(k) plans are both popular types of defined contribution retirement plans, but they differ primarily in who contributes and the nature of those contributions.
| Feature | Profit Sharing Plan | 401(k) Plan |
|---|---|---|
| Primary Contributor | Employer only. Contributions are discretionary and typically tied to company profits or performance. | Both employee and employer (optional). Employees make pre-tax elective deferrals from their salary. Employers may offer matching or non-elective contributions. |
| Contribution Nature | Flexible, non-guaranteed contributions determined by the employer annually. The employer can choose to contribute nothing in a given year. | Employee contributions are regular and chosen by the employee (within IRS limits). Employer contributions (if offered) can be matching, non-elective, or profit-sharing. |
| Contribution Basis | Usually a percentage of company profits or a discretionary amount. | Employee contributions are a percentage of their salary. Employer contributions are often a percentage of employee deferrals or compensation. |
| Benefit to Employee | Provides additional retirement savings funded entirely by the employer, creating a direct link between company success and employee benefit. | Allows employees to save their own money on a tax-deferred basis, with potential for employer-matched funds, giving employees more direct control over their savings. |
| Common Setup | Often set up as a standalone plan, but can also be combined with a 401(k) plan. | Typically a standalone plan, though many 401(k) plans incorporate a profit sharing component, allowing discretionary employer contributions in addition to employee deferrals. |
While a profit sharing plan focuses exclusively on employer-driven, flexible contributions, a 401(k) plan is primarily designed around employee salary deferrals. Many companies offer a "401(k) with profit sharing" feature, which combines the ability for employees to save their own pre-tax money with the employer's flexibility to add discretionary contributions.
FAQs
Q1: Do employees contribute to a profit sharing plan?
No, typically, only the employer contributes to a profit sharing plan. Employees do not make direct contributions from their salary to this type of plan. The contributions come solely from the company's funds.
Q2: Are profit sharing contributions guaranteed every year?
No, profit sharing contributions are generally not guaranteed. Employers have the flexibility to decide each year whether to make a contribution and how much to contribute, often based on the company's profitability or financial health.
Q3: How are profit sharing contributions allocated among employees?
Contributions are allocated based on a formula defined in the plan document. Common methods include allocating contributions proportionally to each employee's compensation, or using age-weighted or "new comparability" formulas that allow for different contribution rates based on various factors.
Q4: Are profit sharing plans subject to taxes?
Employer contributions and the earnings on investments within a profit sharing plan grow tax-deferred. This means participants do not pay taxes on these amounts until they withdraw them, typically in retirement planning. However, the employer's contributions are generally tax-deductible tax advantages as a business expense.
Q5: Can a small business set up a profit sharing plan?
Yes, small businesses can set up profit sharing plans. These plans are often attractive to small businesses because they offer flexibility in contributions, allowing businesses to adjust contributions based on their financial capacity in a given year.