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 type of 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.

Next Up

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 a profit-sharing plan is created by an employer, it is up to the business as to how much it wants to allocate to each employee. Companies that offer a profit-sharing plan have the opportunity to adjust the plan as needed, sometimes making zero contributions in some years. In the years when contributions are made, 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, each employee's annual compensation is divided 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 decides to share 10% of the annual profits, and the business earns \$100,000 in a given fiscal year, the profit share would be allocated 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 it can be established even if a company 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.

The contribution limit for a company sharing its profits to an employee is the lesser of 25% of that employee's compensation or \$53,000. 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.

RELATED TERMS
1. Employee Contribution Plan

An employee contribution plan is an employer-sponsored savings ...
2. Qualified Retirement Plan

Your employer might offer one or more qualified retirement plans, ...
3. 401(k) Plan

A 401(k) plan is an employer-sponsored retirement account that ...
4. Cash or Deferred Arrangement (CODA)

A Cash or Deferred Arrangement (CODA) is a specific method of ...
5. Highly Compensated Employee

A highly compensated employee (HCE) is anyone who owns at least ...
6. Money-Purchase Pension Plan

A pension plan to which employers and employees make contributions ...
Related Articles
1. Investing

Delta's Unique Employee Structure and Its Logic Behind It (DAL)

Find out if new profit sharing will affect the unionization efforts of Delta employees or if bigger raises keep employees happy in this unique workforce.
2. Retirement

Work in the Gig Economy? Don't Miss Out on Retirement Savings

Here are 5 smart ways the self-employed can save for retirement. Don't miss out – and get financial advice before picking a strategy.

Deferred Compensation Plans for Small Business Owners

Find out the best tax-qualified options business owners can use to defer their compensation and accumulate capital for their retirement.
4. Retirement

How Small Business Owners Can Save More for Retirement

A retirement planning strategy that can help small business owners keep more of their earnings.
5. Retirement

The Basics of a 401(k) Retirement Plan

This plan has become one of the most popular retirement options. Here's why.

Small Business Retirement Plans You Should Know

For many reasons, it is important for the small business owner to have a retirement plan in place. Here are some options.
7. Retirement

How to Really Take Charge of Your Retirement Plan

Business owners and those who are self-employed may find that their 401(k) plans aren't enough.
8. Retirement

Employees aren't the only ones who benefit from 401(k) plans. Small business owners can too.
9. Retirement

Retirement Savings Tools I: Employer Savings Plans

There are a variety of employer savings plans that can offer multiple routes to saving for retirement.
RELATED FAQS
1. How is withdraw from profit-sharing plan compared to 401k?

Whether you can use your profit-sharing funds depends on constraints that may prevent you from withdrawing the money from ... Read Answer >>
Hot Definitions
1. Economies of Scale

Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
2. Quick Ratio

The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
3. Leverage

Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
4. Financial Risk

Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
5. Enterprise Value (EV)

Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
6. Relative Strength Index - RSI

Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...