How Does Profit Sharing Income Work?
Understand how your employer's profit sharing plan works, from company contribution to your ownership, and the key financial rules for accessing your funds.
Profit sharing income is a form of retirement savings provided by an employer, allowing a company to share its financial success with its workforce. These plans are entirely funded by the employer, meaning employees do not contribute their own money. The purpose is to offer a retirement benefit tied to the company’s performance, aligning the interests of employees with the business’s financial health.
These contributions are made into a defined contribution plan, where the funds are invested to grow over time. Unlike a regular salary, this income is not immediately available and is held in a trust account subject to specific rules. The structure of these plans is governed by federal regulations to ensure they are managed for the benefit of employees and their beneficiaries.
Understanding Profit Sharing Plan Contributions
An employer has flexibility in deciding how to calculate the amount it contributes each year. While contributions must be substantial and recurring to maintain the plan’s qualified status with the IRS, the specific method for determining the amount can vary. This allows companies to adjust contributions based on their financial performance.
One approach is the discretionary method, where the company’s management decides each year whether to make a contribution and how much. Another method involves a predetermined formula that might specify the company will contribute a certain percentage of its net profits to the plan.
To receive a contribution, an employee must meet eligibility requirements. An employer cannot require more than one year of service, defined as working at least 1,000 hours in a 12-month period, or a minimum age of 21.
Recent legislation has expanded eligibility for long-term, part-time employees. For plans that also allow employee contributions, such as 401(k)s with a profit-sharing feature, employers must allow participation for employees who have worked at least 500 hours in two consecutive years.
Vesting Schedules and Contribution Limits
Vesting determines your ownership of the employer’s contributions over time and serves as an incentive for employees to remain with the company. If you leave your job before you are fully vested, you may have to forfeit some or all of the profit sharing funds in your account. Any funds that are forfeited can be used by the employer to reduce future contributions or cover plan administration costs.
Two primary types of vesting schedules are permitted. A three-year “cliff” schedule means an employee has zero ownership for their first three years of service and becomes 100% vested after the third year. A “graded” schedule allows for incremental ownership over two to six years, such as gaining 20% ownership after two years and an additional 20% each year until 100% vested after six years.
The Internal Revenue Service (IRS) places limits on the total amount that can be contributed to an employee’s account each year. For 2025, the total contribution limit for defined contribution plans is the lesser of 100% of the employee’s compensation or $70,000. This limit encompasses all employer contributions, including profit sharing and 401(k) matches, as well as employee contributions to a 401(k). The employer’s deduction for contributions is limited to 25% of the total compensation paid to all eligible employees.
Tax Treatment of Distributions
When you withdraw money from your profit sharing account, the distributions are subject to federal income tax. The funds are taxed as ordinary income, not at the lower capital gains rates. This means the amount you withdraw is added to your other income for the year and taxed at your marginal tax rate. The tax treatment is similar to that of distributions from a traditional 401(k) or IRA.
If you take a distribution from your profit sharing plan before reaching age 59½, you will owe a 10% additional tax on the taxable portion of the withdrawal, on top of regular income tax. However, numerous exceptions to this penalty exist for events like death, total and permanent disability, terminal illness, or for victims of domestic abuse. Because many specific conditions apply, it is important to understand the current rules before taking an early distribution.
After the end of any year in which you receive a distribution, the plan administrator is required to send you and the IRS a Form 1099-R. This form reports the total amount of the distribution and the taxable amount. It also includes codes that provide the IRS with more information about the nature of the distribution, which helps determine if any penalties apply.
Accessing Your Profit Sharing Funds
You can access the funds in your profit sharing account upon experiencing a specific triggering event. The most common events include separation from service, reaching the plan’s designated retirement age, or becoming permanently disabled. The plan’s official documents will specify the exact circumstances under which you are permitted to take a distribution of your vested balance.
Once a triggering event occurs, you have two primary options for accessing your money. The first option is to take a lump-sum cash distribution. If you choose this path, the plan administrator is required to withhold a mandatory 20% of the taxable portion for federal income taxes. This 20% is a prepayment of your tax liability, and you will reconcile the difference when you file your annual tax return.
The second option is a direct rollover. This involves instructing the plan administrator to transfer your vested account balance directly to another eligible retirement plan, such as a traditional IRA or your new employer’s 401(k) plan. A direct rollover avoids the mandatory 20% withholding and allows the funds to remain tax-deferred, continuing to grow without immediate tax consequences.