Discretionary Profit Sharing Plan Rules Explained

A discretionary profit sharing plan is an employer-sponsored retirement plan that offers flexibility. Unlike plans requiring fixed contributions, an employer with a discretionary plan can decide annually whether to contribute and how much to provide based on the company’s financial performance. This allows a business to make large contributions in profitable years and reduce or skip them in leaner times. The contributions are made by the employer and deposited into separate accounts for each eligible employee. While contributions are optional, the method for dividing them among employees must follow specific rules outlined in the plan’s legal documents.

Contribution and Allocation Rules

An employer’s deductible contribution to a discretionary profit sharing plan is governed by federal limits. The total contribution is capped at 25% of the total compensation paid to all eligible employees. For 2025, the maximum amount of an individual employee’s compensation that can be considered for this calculation is $350,000.

There are also constraints on the total amount that can be allocated to any single employee’s account each year. For 2025, annual additions to a participant’s account, which include employer contributions and any reallocated forfeitures, cannot exceed the lesser of 100% of the employee’s compensation or $70,000.

The method for dividing the employer contribution among employees must be detailed in the plan document. A common approach is the pro-rata method, where each employee receives an allocation that is the same percentage of their salary. For example, if the employer contributes 5% of total eligible payroll, every employee receives a contribution equal to 5% of their individual compensation.

Another allocation method involves integrating the plan with Social Security, also known as permitted disparity. This approach allows employers to contribute a higher percentage of compensation for earnings above the Social Security wage base. The logic is to provide a supplemental retirement benefit for earnings not covered by Social Security, but the method requires careful calculations to avoid unfairly favoring highly compensated employees.

An additional option is the new comparability formula, which is a form of cross-testing. This method allows an employer to group employees into different classes, such as owners and other staff, and assign a different contribution rate to each class. For this to be permissible, the plan must undergo annual non-discrimination testing. This testing ensures that when contributions are projected to retirement age, the benefits for lower-paid employees are comparable to those for higher-paid employees.

Plan Establishment and Deadlines

To create a discretionary profit sharing plan, a business must adopt a formal written plan document. This document outlines all its rules, including eligibility, contribution allocation formulas, and vesting schedules. Employers have two choices for this document: a pre-approved prototype plan from a financial institution or a custom-designed document from a benefits attorney. Prototype documents are standardized and cost-effective, while custom documents offer more flexibility.

The deadline for establishing a new plan and depositing the contribution is the due date of the company’s federal income tax return, including extensions. This allows a business to decide on creating a plan after its fiscal year has closed. For a calendar-year company that files for an extension, this means both the plan adoption and the contribution for the 2025 tax year could be completed as late as October of the following year.

Funding and Vesting Mechanics

Vesting refers to an employee’s ownership right to the funds in their retirement account. While employees are always 100% vested in any contributions they make themselves, employer contributions are typically subject to a vesting schedule. This schedule determines the percentage of the employer’s contribution that an employee owns based on their length of service.

The Internal Revenue Service permits a few standard vesting schedules. One option is a “cliff” schedule, where an employee becomes 100% vested after a specific period, such as three years of service, but is 0% vested before that date. Another choice is a “graded” schedule, which allows for incremental vesting. For example, a six-year graded schedule might grant 20% ownership after two years of service, increasing by 20% each year until the employee is fully vested after six years.

If an employee leaves the company before becoming fully vested, the non-vested portion of their account is forfeited. These forfeited funds do not return to the employer but remain in the plan’s trust. The plan document specifies how these forfeitures can be used, such as to reduce future employer contributions or be reallocated among the remaining plan participants.