As a working professional, you have a variety of options when it comes to retirement planning and retirement plans themselves. While the 401(k) and IRA are two of the most common retirement plans people participate in — or that their employers voluntarily pay into — profit-sharing plans are another option available to employees at some companies.
Knowing how profit-sharing plans work is important if your company offers one and when you want to make wise retirement planning decisions. Understanding the basics can help you determine if this savings strategy is best for your financial situation and long-term goals. If you’re asking yourself, “How does profiting-sharing work?” here’s what you need to know.
Profit-Sharing Plan Basics: What They Are and How they Work
A profit-sharing plan is an approach to retirement savings. The strategy provides employees with a specified share of an employer’s profits instead of a set dollar amount invested in stocks, mutual funds, exchange-traded funds or similar investment products.
Profit-sharing plans allow employees to benefit from strong company performance. Usually, a specific share — often a percentage of the company’s earnings — is designated for each worker participating in this type of plan. When profits are calculated, either quarterly or annually, participating employees receive a contribution from the company that’s equal to their specified share of the profits.
If the company has a particularly profitable year, employees benefit more by receiving a larger contribution. If it’s a low-performing year, the amount they receive declines accordingly.
Here’s an example. Imagine an employee who receives a 5% share of profits. (Keep in mind that percentages are typically lower; we’re using 5% for clearer illustration.) If the company earns different amounts of profit over the course of three years — such as $100,000, $150,000 and $80,000 in years one, two and three, respectively — the employee would receive different contribution amounts in accordance with those shifts.
The calculation for determining the amount is [share size converted into decimal] * [profit]. Based on the amounts above, the employee would receive the following contributions:
- Year One: $5,000
- Year Two: $7,500
- Year Three: $4,000
Unlike other kinds of retirement planning, profit-sharing is typically non-contributory. This means employees don’t divert part of their salary toward the plan. Instead, the employer is the only one contributing, using an employee’s share and the company’s profits to determine the amount awarded to each worker.
Often, the profits are used to fund a qualifying tax-deferred retirement account. However, some companies use different approaches, allowing employees to receive their share of the profit in company stock or even cash.
In some ways, the arrangement can encourage employees to strive for better performance, as they receive a direct financial benefit for boosting profitability. However, profit-sharing plans can also make retirement planning more complicated to manage because contributions aren’t predictable from one year to the next.
How Are Profit Shares Determined?
Companies can use a variety of approaches to allocate shares of profit. One of the most widely used is the comp-to-comp method. With it, the employer totals the sum of all employee salaries. Then, it divides an individual worker’s pay by that amount. For instance, if the total value of all employee salaries is $500,000 and Joseph has a salary of $50,000, Joseph’s share would be $50,000 / $500,000, which equals 0.10 or 10%. Joseph is entitled to this much of the company’s profit as his profit share.
Companies don’t have to follow that specific formula, though. Some use other set calculations to determine all employee shares. Others assign rates at their discretion, making the rate potentially negotiable. However, the latter isn’t particularly common at large companies with numerous employees who may participate, as it could make tracking the total amount shared a more complex process.
How Does Profit Sharing Compare to 401(k)s and IRAs?
Profit-sharing plans can have a bit in common with 401(k)s and IRAs if an employee puts the contributions into a tax-deferred retirement account. When that’s the case, the growth and taxation potential are similar.
However, profit-sharing doesn’t guarantee a specific employer contribution. Instead, it’s determined based on the company’s profitability over a defined period of time, which means it can fluctuate. Additionally, employees don’t typically contribute to profit-sharing plans, which differs from both 401(k)s and IRAs in most cases.
Profit-sharing also differs from non-retirement-related investing. Unlike purchasing stocks through a brokerage, profit-sharing accounts are bound by contribution limits and withdrawal restrictions if the money is sent to a retirement account. However, if the company provides the share another way — like giving it to the employee as a cash bonus — that isn’t necessarily the case.
Profit-Sharing Rules, Restrictions and Regulations
As with other kinds of retirement accounts, the IRS does place some contribution restrictions on profit-sharing plans. In 2022, the limit is the lesser of 100% of a person’s compensation, or $61,000. After 2022, the limit is subject to cost-of-living adjustments, meaning it’ll shift over time in response to economic factors like inflation.
Also, like other retirement plans, there are restrictions on withdrawals. While early withdrawals are technically allowed, if a person is under the age of 59 ½ years old, they may have to pay a 10% penalty for making that early withdrawal.
The main drawback of profit-sharing plans is that employees aren’t guaranteed a specific contribution. While it’s true that they may also receive more than they anticipated if profits are high, during downturns, contributions may decline dramatically — potentially hitting $0.
Since the contributions can fluctuate, this type of incentive plan also makes long-term retirement planning more difficult. Employees won’t know from year to year how much they’ll receive. In turn, they may not know if they’ll be able to set aside enough to build a comfortable retirement nest egg based on these earnings. And, they may feel compelled to have a separate retirement account to help mitigate that risk.
