Profit-Sharing Plan
A profit-sharing plan is a type of defined contribution retirement plan in which an employer makes discretionary contributions to employee accounts, typically based on company profits, though contributions need not be tied to profitability and can be made in any year.
Profit-sharing plans are among the oldest and most flexible employer-sponsored retirement plan types. Governed by ERISA and the Internal Revenue Code, they allow the sponsoring employer to make tax-deductible contributions to individual participant accounts without being required to contribute in any given year or at any specified level. This flexibility distinguishes them from defined benefit plans, which impose mandatory minimum funding requirements, and from safe harbor 401(k) plans, which require fixed employer contributions.
The annual employer contribution limit under IRC Section 415 for a profit-sharing plan is the lesser of 100% of the participant's compensation or $69,000 for 2024. The employer's tax deduction for contributions to all profit-sharing plans covering an employee is limited to 25% of the aggregate compensation of all eligible participants. Within those limits, the employer has broad discretion to determine each year whether to contribute and how much.
Profit-sharing plans can be structured as standalone plans or combined with 401(k) plans. In a combined 401(k)/profit-sharing plan, employees make elective deferrals under the 401(k) component while the employer makes profit-sharing contributions — both counting toward the same Section 415 annual limit. This structure is common in closely held businesses because it maximizes the total tax-deductible contribution to the owner's account.
The allocation of employer profit-sharing contributions among participants must follow a nondiscriminatory method. The most common is a pro-rata allocation based on each participant's share of total plan compensation. However, plans can adopt age-weighted or new comparability (cross-tested) formulas that legally allocate a disproportionate share to older or higher-paid employees — including the business owner — provided the plan passes IRS nondiscrimination testing, which compares the allocation rate received by highly compensated employees to that received by non-highly compensated employees.
Vesting schedules for profit-sharing contributions can range from immediate vesting to a schedule extending up to six years (for graduated vesting) or three years (for cliff vesting) under ERISA-mandated maximums. The SECURE 2.0 Act of 2022 changed long-term part-time employee eligibility rules, requiring plans to allow participation by employees who work at least 500 hours per year for two consecutive years beginning in 2025, which affects profit-sharing plan design for employers with significant part-time workforces.