How Does a Deferred Profit Sharing Plan Work?
Understand the mechanics of a deferred profit sharing plan, from how an employer funds accounts to an employee's path to accessing retirement benefits.
A deferred profit sharing plan (DPSP) is a retirement plan established by an employer that allows a company to make contributions for its employees based on profitability. As a defined contribution plan, the final benefit depends on the contributions and the investment performance of the account’s funds. This structure allows employers to share financial success with their workforce through a savings vehicle that grows on a tax-deferred basis.
Core Features and Contribution Rules
A defining characteristic of a DPSP is the employer’s flexibility regarding contributions. An employer has the discretion to decide how much to contribute each year based on company profits. Contributions can vary annually, and an employer may choose to contribute nothing in years with low profits, which contrasts with other retirement plans that mandate fixed contributions.
Only the employer can make contributions to a traditional DPSP. When a contribution is made, the funds must be allocated among eligible employees, often using a pro-rata formula based on compensation. For instance, if an employee’s salary is 5% of the total compensation for all eligible employees, they would receive 5% of that year’s profit-sharing contribution.
The Internal Revenue Service (IRS) sets limits on these contributions. For 2025, the total contribution to an employee’s account cannot exceed the lesser of 100% of their compensation or $70,000. This limit applies to the total of all contributions made to an employee’s defined contribution plans with that employer.
From the employer’s perspective, there is a limit on the tax deduction they can claim for contributions. A business can deduct contributions up to 25% of the total compensation paid to all eligible employees. This deduction provides a tax incentive for the employer, encouraging them to fund the plan to share profits and reduce their own taxable income.
Employee Participation and Vesting
To participate in a DPSP, an employee must meet eligibility requirements outlined in the official plan document. These rules often involve reaching age 21 and completing a minimum period of service, such as one year. Once these conditions are met, the employee becomes a participant and is eligible to receive a share of any employer contributions.
Vesting determines an employee’s ownership of the employer contributions in their account. Since a DPSP consists only of employer funds, these are subject to a vesting schedule, which encourages employees to remain with the company. There are two primary types of vesting schedules permitted by the IRS: cliff and graded.
With a three-year cliff vesting schedule, an employee has no ownership for the first three years of service. After completing the third year, they become 100% vested in their account balance. Leaving before the three-year mark results in forfeiting all funds.
The alternative is a graded vesting schedule, which allows for partial ownership over time. A common six-year graded schedule might grant 20% ownership after two years of service, with the percentage increasing annually until the employee is 100% vested after six years. If an employee leaves while only partially vested, they are entitled to that portion of their account.
The remaining non-vested portion is forfeited. These forfeited funds are returned to the employer, who can use them to reduce future contributions or reallocate them among the remaining plan participants.
Accessing Plan Funds
An employee can withdraw money from their DPSP account upon specific triggering events outlined in the plan document. These events include:
- Separation from service
- Reaching the plan’s designated retirement age
- Death
- Becoming disabled
The funds must be made available to the participant within 90 days of one of these events.
Taking a lump-sum cash payment will result in the entire amount being treated as ordinary income for that tax year. If the employee is under age 59½, they may also face an additional 10% early withdrawal penalty.
To avoid immediate taxation, an employee can choose a direct rollover to another qualified retirement plan, such as an IRA or a new employer’s 401(k). By executing a direct rollover, the funds maintain their tax-deferred status. The money continues to grow without being taxed until withdrawn from the new account during retirement.
Some DPSP documents allow for accessing funds while still employed through plan loans or hardship withdrawals. Plan loans let an employee borrow against their vested balance and repay it with interest. Hardship withdrawals are for immediate financial needs but are subject to strict IRS criteria and are taxable events.
Establishing and Administering the Plan
Setting up a DPSP involves several formal steps to ensure regulatory compliance. The employer must first adopt a formal written plan document. They can choose a standardized, IRS-approved prototype plan or a more flexible and costly individually designed plan.
The employer must then establish a trust to hold the plan’s assets for the participants. A trustee, which can be an individual or a financial institution, is appointed to manage the trust, overseeing contributions, investments, and distributions. The employer must also provide clear notification to all eligible employees about the plan’s features and their rights.
The primary administrative duty is filing Form 5500 annually with the Department of Labor, which reports on the plan’s finances and operations. The specific version of the form depends on the plan’s size. This annual reporting is necessary to maintain the plan’s qualified status.