What Is a Profit Sharing Account & How Does It Work?

A profit sharing account is an employer-sponsored retirement plan that allows businesses to contribute to their employees’ retirement savings. The employer’s decision to contribute is discretionary, meaning they can choose each year whether to make contributions and how much, based on business conditions. This flexibility helps companies support their employees’ long-term financial well-being.

Understanding Profit Sharing Accounts

A profit sharing account is a defined contribution retirement plan where an employer contributes a portion of company profits, or even non-profit amounts, to individual employee retirement accounts. This type of plan aims to motivate employees by directly linking their financial benefits to the company’s performance. Each eligible employee has a separate account, and the value of their retirement savings grows over time based on these contributions and investment returns.

These plans are available to businesses of various sizes, from sole proprietorships to large corporations. The employer maintains flexibility in their contributions, which are not mandatory every year and can vary based on the business’s financial health. This discretionary nature means an employer can choose to contribute nothing in a given year if business conditions require it.

Contribution Rules and Limits

Employer contributions to a profit sharing plan are discretionary. This allows businesses to adjust contributions based on their financial performance. Even if a company does not generate a profit in a particular year, it can still make contributions to the plan.

The method for allocating contributions among eligible employees must be clearly defined in the plan document. Common allocation methods include pro-rata, where contributions are a uniform percentage of each employee’s compensation. Age-weighted and new comparability plans can favor older or specific groups of employees while still adhering to non-discrimination rules. Employers can also set eligibility requirements for employees to participate, such as reaching age 21 and completing one year of service with at least 1,000 hours worked.

The Internal Revenue Service (IRS) sets maximum annual contribution limits for defined contribution plans, including profit sharing plans. For 2024, the total amount contributed to an employee’s account, including employer contributions and any forfeitures, cannot exceed the lesser of 100% of the employee’s compensation or $69,000. For 2025, this limit increases to $70,000. These limits apply to the total amount contributed across all defined contribution plans for an individual. Employer contributions to a qualified profit sharing plan are tax-deductible for the business, typically up to 25% of the total compensation paid to all participants for the taxable year. The funds within these accounts grow tax-deferred, meaning taxes are not due on the earnings until they are distributed to the employee.

Vesting and Distribution of Funds

Vesting in a profit sharing account refers to the process by which an employee gains non-forfeitable ownership of the employer’s contributions. This means the employee has a right to the funds, even if they leave the company. Common vesting schedules include “cliff vesting,” where an employee becomes 100% vested after a specific period, such as three years. “Graded vesting” increases ownership gradually over several years, for example, 20% each year, reaching 100% after six years.

Employees can typically access their vested funds upon certain events, such as retirement, termination of employment, disability, or death. Distributions can be received in various ways, including a lump-sum payment or through rollovers to an Individual Retirement Account (IRA) or another qualified retirement plan. These rollovers allow the funds to continue growing on a tax-deferred basis.

Distributions from a profit sharing account are generally taxed as ordinary income in retirement. If funds are withdrawn before age 59½, they may be subject to an additional 10% early withdrawal penalty, unless a specific exception applies.

How Profit Sharing Accounts Compare to Other Retirement Plans

Profit sharing accounts differ from other common retirement plans in their design and contribution mechanisms. A significant distinction exists when comparing them to 401(k) plans. While a 401(k) plan primarily allows employees to contribute a portion of their salary on a pre-tax or Roth basis, profit sharing plans are funded solely by employer contributions. A profit sharing feature can, however, be incorporated into a 401(k) plan, allowing for both employee deferrals and employer discretionary contributions.

In contrast to defined benefit plans, which promise a specific, predetermined payout at retirement, profit sharing accounts are defined contribution plans where the final benefit depends on contributions and investment performance. In a defined benefit plan, the employer bears the investment risk, whereas in a profit sharing plan, the employee’s account balance fluctuates with market performance.

When looking at plans commonly used by smaller businesses, profit sharing plans offer different characteristics than Simplified Employee Pension (SEP) IRAs or Savings Incentive Match Plan for Employees (SIMPLE) IRAs. SEP IRAs are funded entirely by employer contributions, similar to profit sharing plans, but are generally simpler to administer and have fewer reporting requirements. However, SEP IRAs require immediate 100% vesting of contributions, unlike profit sharing plans which can have vesting schedules.

SIMPLE IRAs allow both employer and employee contributions, often with mandatory employer matching. This differs from the discretionary nature of profit sharing contributions. While SEP and SIMPLE IRAs can be easier to set up, profit sharing plans often offer greater flexibility in allocation methods and the ability to implement vesting schedules.