Profit-sharing plans: Retirement money, not a bonus

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Tax-advantaged savings to help build your nest egg.

© abramsdesign/stock.adobe.com, © kamui29/stock.adobe.com; Photo illustration Encyclopædia Britannica, Inc

Profit-sharing plans are a common workplace retirement benefit, although the name can be misleading. These plans aren’t directly tied to company performance. Instead, they provide a way for employers to contribute money to employees’ retirement accounts, often alongside a 401(k) plan.

How much goes in, who qualifies, and when the money becomes yours depend on the plan’s rules.

A profit-sharing plan is a workplace retirement plan funded entirely by employer contributions. Despite the name, it isn’t a cash bonus tied to company profits or individual performance. Profit-sharing plans are governed by the Employee Retirement Income Security Act (ERISA) of 1974, like most employer-sponsored retirement plans.

Profit-sharing plans work much like 401(k) plans in a key way: Your employer contributes money to an individual account in your name—which is why it’s sometimes referred to as “free money”—and those funds grow tax deferred until retirement. Internal Revenue Service rules permit only employers to fund these plans; employees contribute none of their own pay.

Some employers combine profit-sharing plans with a 401(k), allowing workers to receive both employer contributions and make their own elective deferrals under a single plan.

Profit-sharing plans are discretionary, meaning employers decide each year whether to contribute and how much to put in. They can also choose not to contribute at all in a given year. When employers do contribute, they must follow IRS guidelines and a written formula that explains how the money is allocated among employees.

One common approach is a pro rata method, or “comp-to-comp,” which allocates contributions based on each employee’s share of total compensation. For example, if total annual employee compensation is $1.2 million and you earn $60,000, your share would be 5% of whatever your employer contributes that year.

The funds your employer contributes to a profit-sharing plan may be subject to vesting, meaning the money may not be yours right away.

If vesting is immediate, then you have full ownership as soon as the contribution is made. With graded vesting, ownership increases gradually, often in increments such as 20% a year over five years. With cliff vesting, you become 100% vested after reaching a specific milestone, such as three years of service.

Federal rules also apply to vesting. If an employer stops contributing to a profit-sharing plan for an extended period, the IRS may treat the plan as terminated for vesting purposes, making affected employees fully vested.

If you leave your job before you’re fully vested, any unvested portion of your employer’s contributions is forfeited and typically returns to the employer.

Some employers offer both a 401(k) and a profit-sharing plan as separate benefits. Others combine the two into a single retirement plan. When they do, the plans tend to work better together, allowing employers to streamline administration and reduce costs.

Under this setup, you can make your own pre-tax or Roth 401(k) contributions, up to IRS limits. Your employer may also match your contributions and add profit-sharing money, all within the same plan.

You don’t need to contribute anything to receive profit-sharing money, but vesting rules may apply. Also, employer contributions don’t count toward your personal 401(k) deferral limit, although the IRS caps the total amount that can go into your account each year when employee and employer contributions are combined.

Like other tax-deferred retirement accounts, profit-sharing plans generally don’t allow withdrawals before age 59½ without a 10% early withdrawal penalty.

Some plans permit in-service withdrawals after age 59½ or allow loans, which must be repaid. Access to the money is also triggered by certain events, such as retirement, disability, death, or leaving your job (whether the termination is voluntary or involuntary).

If you leave your employer, you have several options for any vested balance. You can typically leave the money in the plan as long as your balance is above its automatic cash-out threshold (often $5,000, although some plans have adopted higher limits), roll it over to a new employer’s retirement plan if allowed, or transfer it to an individual retirement account (IRA).

Cashing out comes at a cost. Withdrawn amounts are taxed as ordinary income in the year you take them, and if you’re younger than 59½, you may also owe an early withdrawal penalty.

When you retire or otherwise leave the workforce, money in a profit-sharing plan is generally treated like other tax-deferred retirement savings. Withdrawals are typically taxed as ordinary income in the year you take them.

Depending on the plan’s rules, you may be able to leave the money in the plan or roll it over to an IRA. Federal tax law and IRS rules determine when distributions can occur and into which accounts retirement money can be rolled without triggering taxes. Employers decide which of those options to offer in their plans, subject to those regulations.

Required minimum distributions (RMDs) typically begin at age 73, with the starting age scheduled to rise to 75 in 2033. Some employer plans allow you to delay RMDs from your current employer’s plan if you’re still working and not a more than 5% owner, but that exception must be written into the plan and doesn’t apply to IRAs or old employer plans.

Profit-sharing plans can be a valuable workplace retirement benefit, particularly when paired with a 401(k). Because contributions are discretionary and often subject to vesting, the details of your plan—especially the vesting schedule—matter when deciding how long to stay with an employer or whether to change jobs.