Profit-Sharing Plans

Profit-sharing plans are a type of defined contribution retirement plan where the amount contributed may vary from year to year. They are benefit plans that allow employers to make contributions to an account that earns investment income and is sheltered from taxation until the money is actually distributed. The employer's contributions are usually based on a percentage of the profits that the business makes, but contributions can be made even if the business makes no profit for the year. Often, profit-sharing plans involve using a 401(k) plan, in which the employee can make voluntary contributions out of his or her pre-tax salary.

Profit-sharing plans involve the risk that the benefits may be inadequate at retirement. Their great advantage from the employer's point of view is that there is no commitment requiring contributions to the plan in lean years.

If you'd like to look at a sample profit-sharing plan to see if you might be interested, the Business Tools area contains a sample plan for a self-employed individual.

Who benefits from profit-sharing plans? Younger employees, short-service employees, employees in lower-pay brackets, and employees who quit after medium lengths of service are those who will benefit most from profit-sharing plans.

Profit-sharing plans cannot meaningfully take into account an employee's (or owner's) years of service for purposes of computing benefits, as a target benefit plan could. The Internal Revenue Service insists that a profit-sharing plan is discriminatory if contributions each year are not allocated to employees on the basis of a uniform relationship to compensation. For this reason, it is virtually impossible to provide greater contributions (and, therefore, greater eventual benefits) for long-service employees in a profit-sharing plan, except to the extent that long-service employees are paid a higher salary.