What Is a Profit Sharing Contribution?

A profit sharing contribution is a type of employer deposit made into an employee’s retirement account. These contributions are distinct from an employee’s own salary deferrals or any employer matching funds in a 401(k) plan. They are entirely discretionary, meaning a company can decide each year whether to make a contribution and how much to provide. Despite the name, these contributions are not strictly tied to a company’s profitability, and an employer can make them even during a year without profits. This mechanism can be part of a standalone profit sharing plan or integrated as a feature within a 401(k) plan.

How Profit Sharing Contributions Work

While there is no mandate to contribute annually, the Internal Revenue Service (IRS) requires that for a plan to maintain its qualified status, contributions must be “substantial and recurring” over time. The IRS may consider a plan terminated if an employer fails to make significant contributions for three out of five consecutive years, which would trigger full vesting for all affected employees.

Once an employer decides to make a contribution, the funds must be allocated among eligible employees according to a predefined formula detailed in the plan document. The most straightforward method is the pro-rata, or comp-to-comp, formula. Under this approach, the total contribution is allocated based on each employee’s compensation relative to the total compensation of all eligible employees. For example, if an employee’s salary represents 5% of the total eligible payroll, they would receive 5% of the profit sharing contribution.

Another common allocation method is permitted disparity, sometimes called Social Security integration. This formula allows employers to contribute a higher percentage of an employee’s pay that is above the Social Security wage base for the year. This method helps provide a more balanced retirement benefit, as the employer’s Social Security tax contributions on behalf of the employee cease above this wage threshold.

A new comparability formula allows a business to group employees into different classes, such as owners, managers, and other staff. Each class can receive a different contribution rate, which provides the flexibility to direct larger contributions to key employees. However, to use this method, the plan must pass annual nondiscrimination testing to prove that the formula does not unfairly favor highly compensated employees.

Contribution Rules and Limits

A business can contribute an amount up to 25% of the total compensation paid to all eligible employees participating in the plan. This limit is calculated on the aggregate payroll of participants, not on an individual employee basis.

For individual employees, there is a separate overall limit on annual additions to their retirement account. This limit encompasses all contributions made on their behalf, including their own 401(k) deferrals, any employer match, and the profit sharing contribution. For 2025, this total limit is the lesser of 100% of the employee’s compensation or $70,000.

The IRS also imposes a cap on the amount of an employee’s annual compensation that can be considered when calculating contributions. For 2025, the compensation limit is $350,000, meaning any salary above this amount is disregarded for calculation purposes. To secure a tax deduction for a specific year, the employer must deposit the contributions by the due date of the company’s federal income tax return, including any filed extensions.

Employee Eligibility and Vesting

An employee must meet specific eligibility requirements outlined in the plan document before receiving a contribution. A plan can require an employee to reach age 21 and complete one year of service, which is defined as working at least 1,000 hours within a 12-month period. Alternatively, a plan can require two years of service, but if it does, all employer contributions must be 100% immediately vested.

Once an employee receives a contribution, their right to that money is determined by a vesting schedule. Vesting is the process of earning ownership of the employer’s contributions over time; an employee’s own 401(k) contributions are always 100% vested immediately. One vesting schedule is “cliff” vesting, where an employee has zero ownership of employer contributions until they complete three years of service, at which point they become 100% vested all at once.

Another option is a “graded” vesting schedule, which might vest an employee’s ownership incrementally over six years. For example, an employee would be 20% vested after two years of service, 40% after three years, and so on until reaching 100% after six years of service. If an employee leaves the company before being fully vested, they forfeit the non-vested portion of their account balance.

These forfeited funds do not return to the employer’s general assets. Instead, they remain in the plan and are commonly used to reduce future employer contributions or are reallocated among the remaining plan participants.

Tax Implications

For the business, contributions are a deductible business expense. When an employer makes a profit sharing contribution within the legal limits, it can deduct the full amount from its business income, lowering its overall tax liability for the year.

For employees, the profit sharing contributions deposited into their retirement account are not considered taxable income in the year they are made. This allows the funds to be invested and to grow on a tax-deferred basis, as earnings, dividends, and capital gains are not taxed annually as they accrue within the account.

Taxes are eventually due when the employee begins to withdraw the funds from their account, typically during retirement. At the time of distribution, the amounts withdrawn are taxed as ordinary income, subject to the individual’s income tax rate in that year.