How Does 401(k) Profit Sharing Work?

A 401(k) plan with a profit-sharing feature is a type of retirement plan where an employer can make additional contributions to their employees’ accounts. These contributions are discretionary, meaning the company decides each year whether to make them and how much to contribute, often based on the firm’s profitability. Unlike a typical employer match, these profit-sharing contributions are not dependent on whether an employee contributes their own money to the 401(k).

The plan is established through a formal written document that outlines its operational rules. This document, along with a summary plan description (SPD), is provided to employees to explain who is eligible and how the plan functions.

The Employer Contribution Process

An employer’s decision to make a profit-sharing contribution is flexible and determined annually. A company can choose to contribute a significant amount in a profitable year or skip the contribution in a less successful year. Once the total contribution amount is decided, the funds must be allocated among the eligible employees using one of several established methods.

The most common allocation method is pro-rata, or comp-to-comp. Under this formula, each employee receives a contribution proportional to their salary relative to the total compensation of all eligible employees. For example, if an employee’s salary represents 2% of the total payroll for eligible staff, they would receive 2% of the total profit-sharing pool.

Another method is allocating a flat dollar amount. With this formula, every eligible employee receives the exact same contribution, regardless of their salary or position within the company. This is calculated by simply dividing the total profit-sharing pool by the number of eligible employees.

A more complex approach is the new comparability formula. This method allows an employer to divide employees into different groups, often based on factors like job function, seniority, or compensation level. Each group can then be assigned a different contribution rate, which often results in higher-paid, older employees receiving a larger share. These plans are subject to nondiscrimination testing by the IRS to ensure they do not unfairly favor highly compensated employees.

All contributions are subject to annual limits set by the Internal Revenue Service. There is a maximum amount that can be contributed to an employee’s account from all sources combined—including employee deferrals, employer match, and profit sharing. For 2025, this limit is the lesser of 100% of the employee’s compensation or $70,000.

Employee Eligibility and Vesting Rules

Before an employee can receive a profit-sharing contribution, they must meet specific criteria outlined in the plan document. Eligibility rules require an employee to reach a certain age, often 21, and complete a specified period of service, such as one year with at least 1,000 hours worked.

Vesting is the process by which an employee earns the non-forfeitable right to the money the employer has put into their account. While an employee is always 100% vested in their own 401(k) contributions, employer contributions, including profit sharing, are subject to a vesting schedule. This schedule serves as an incentive for employees to remain with the company.

One common vesting schedule is cliff vesting. Under this model, an employee gains 100% ownership of all employer contributions after completing a specific period of service, but they have 0% ownership before that date. Federal law dictates that a cliff vesting schedule cannot be longer than three years. If an employee leaves before completing the service requirement, they forfeit the entire profit-sharing balance.

The other widely used schedule is graded vesting. This approach allows an employee to gain ownership of employer contributions incrementally over time. A common graded schedule might grant an employee 20% ownership after their second year of service, increasing by 20% each subsequent year until they are 100% vested after six years. If an employee leaves after three years, they would be entitled to 40% of their profit-sharing account balance.

Should an employee leave the company before they are fully vested, any non-vested funds are forfeited and returned to the employer. The employer can then use this money to reduce future contributions or to pay for administrative expenses of the plan.

Taxation and Accessing Your Funds

Profit-sharing contributions made by an employer are deposited into an employee’s 401(k) on a pre-tax basis. This means the employee does not pay income tax on the contributed amount in the year it is made. The funds within the account then grow tax-deferred, meaning no taxes are paid on investment earnings as long as the money remains in the plan.

When an employee eventually takes money out of the 401(k) during retirement, after age 59 ½, those distributions are taxed as ordinary income. The tax rate applied depends on the individual’s total taxable income for that year.

Upon separating from the company, an employee can execute a direct rollover. This involves moving the funds directly from the old employer’s 401(k) into another qualified retirement account, such as an IRA or the 401(k) plan of a new employer. A direct rollover preserves the tax-deferred status of the money and avoids any immediate taxes or penalties.

An employee could instead choose to cash out the account by taking a lump-sum distribution. The plan administrator is required to withhold a mandatory 20% for federal income taxes. If the employee is under the age of 59 ½, they will likely face an additional 10% early withdrawal penalty from the IRS, on top of the ordinary income tax due.

Depending on the plan’s rules, an employee might have the option to leave the funds in the former employer’s 401(k) plan. Plans are required to allow this if the vested balance is over a certain threshold, often $5,000. This can be a reasonable choice if the employee is satisfied with the plan’s investment options and fees.