What is a Profit-Sharing Plan
A profit-sharing plan, also known as a deferred profit-sharing plan or DPSP, is a plan that gives employees a share in the profits of a company. Under this plan, an employee receives a percentage of a company's profits based on its quarterly or annual earnings. This is a great way for a business to give its employees a sense of ownership in the company, but there are typically restrictions as to when and how a person can withdraw these funds without penalties.
BREAKING DOWN Profit-Sharing Plan
A profit-sharing plan is any retirement plan that accepts discretionary employer contributions. This means a retirement plan with employee contributions, such as a 401(k) or something similar, is not a profit-sharing plan because of the personal contributions. Since the employer sets up the profit-sharing plan, the business decides how much it wants to allocate to each employee. Companies that offer a profit-sharing plan adjust the plan as needed, sometimes making zero contributions in some years. In the years when they make contributions, however, a company must come up with a set formula for profit allocation.
Comp-to-Comp Method of Profit-Sharing
The most common way for a business to determine the allocation of a profit-sharing plan is through the comp-to-comp method. Using this calculation, an employer derives the sum of all of its employees' compensation. Then, to determine what percentage of the profit-sharing plan an employee is entitled to, the company divides each employee's annual compensation by the sum of the total compensation.
If, for example, a business has two employees, it could use a comp-to-comp method for profit sharing. Let's say employee A earns $50,000 a year and employee B earns $100,000 a year. If the business owner shares 10% of the annual profits and the business earns $100,000 in a fiscal year, the company would allocate profit share as: Employee A = ($100,000 * 0.10) * ($50,000 / $150,000) and employee-B = ($100,000 * 0.10) * ($100,000 / $150,000).
Other Things to Know About Profit Sharing
A profit-sharing plan is available for a business of any size and a company can establish one even if it already has other retirement plans. Further, a company has a lot of flexibility in how it can implement a profit-sharing plan. Like with a 401(k) plan, an employer has full discretion over how and when it makes contributions. However, all companies have to prove a profit-sharing plan that does not discriminate in favor of highly compensated employees.
As of 2018, the contribution limit for a company sharing its profits to an employee is the lesser of 25% of that employee's compensation or $55,000. To implement a profit-sharing plan, all businesses must fill out a Form 5500-series return/report and disclose all participants of the plan. Early withdrawals, just like with other retirement plans, are subject to penalties.