Key Takeaways
- A profit-sharing plan is a defined contribution plan through which employees receive a share of their employer’s profits.
- Employee eligibility in a profit-sharing plan can be restricted to those who have worked a stated number of hours or for a certain period.
- While only employers may contribute to profit-sharing plans, employers as well as employees can contribute to 401(k) plans.
It is important for pre-retirees, particularly younger employees, to understand profit-sharing plans, which offer an additional way to grow retirement savings. Here are essential insights into how profit sharing plans work and how their benefits compare to traditional 401(k) retirement plans.
A profit-sharing plan is a defined contribution plan through which employees receive a share of their employer’s profits. It is in addition to employees’ regular compensation.
While such contributions can enhance retirement savings, they are independent of any employee contribution retirement plan. Thus, all eligible employees receive a profit-sharing contribution.
What is Profit Sharing About?
A company typically offers a profit-sharing plan to help instill in its employees a sense of ownership. It generally seeks to reward employees for their part in the company’s success and motivate employees to continue reaching organizational goals.
It is the companies that establish profit-sharing plans and decide how much will be allocated to each employee. They adjust such plans as necessary, and some years make no contributions. In the years that contributions are made, the companies must have a predefined allocation formula.
There is no single way to allocate profit-sharing funds. Some companies give the same percentage of profits to each employee, their salary notwithstanding. Most often, a company will use the comp-to-comp method.
With this method, the employer will find the sum total of all its employees’ pay. Next, to establish what percentage of the plan an employee is entitled to, the company divides every employee’s annual pay by that total. To determine the amount due to that employee, the percentage is multiplied by the total profits being shared.
Say a company with two employees employs a comp-to-comp profit-sharing method. Here, employee P earns $50,000 annually, while employee Q makes $100,000 a year. If the company earns $100,000 in a fiscal year, and shares 10% of profits, allocation will look thusly:
Employee P = ($100,000 X 0.10) X ($50,000/$150,000), or $3,333.33.
Employee Q = ($100,000 X 0.10) X ($100,000/$150,000), or $6,666.67.
Profit Sharing Plan Rule
In a defined contribution plan, the most that can be contributed to an employee’s account is the lesser of the total of the participant’s compensation — for 2024, the maximum is $69,000. For companies that have more than one defined contribution plan, a single annual cap applies to all plans.
Further, a company’s deduction for contributions to a profit-sharing plan cannot exceed more than 25% of total pay for the year. For 2024, the maximum compensation that can be used for each employee is $345,000, according to the Internal Revenue Service.
Employee eligibility in a profit-sharing plan can be restricted to those who have worked a stated number of hours or for a certain period. Additionally, a company may opt to exclude nonresident aliens, union employees, and those under age 21. A company may put in place other exclusions based on job classification.
Types of Profit Sharing Plans
There are multiple types of profit-sharing plans, including:
- Cash-based. Here, companies make direct cash payments to an employee’s account.
- Deferred. These work like a defined contribution plan for retirement savings. Employers make contributions to an employee’s retirement account, typically for additional tax benefits, but employees may only access the account when they retire or exit the company.
- Combination. These are usually a mix of deferred and cash plans. Companies here contribute to an employee’s retirement account and contribute to a deferred plan for long-term tax favorability.
- Traditional. This type of plan uses the salary ratio method, which is crafted to allocate contributions to all employees on a uniform basis.
Profit Sharing Plan vs. 401(k)
A 401(k) plan is an employer retirement plan that permits employees to make yearly contributions up to a certain limit and invest the money for the future. The chief difference between this kind of plan and profit-sharing plans is who can contribute.
While only employers may contribute to profit-sharing plans, employers as well as employees can contribute to 401(k) plans. Because all employee contributions to a 401(k) plan are 100% vested, they belong to the employee. However, companies contributing to a profit-sharing plan can impose vesting requirements.
Profit Sharing Plan After Leaving a Company
If profit sharing is a key portion of an employee’s compensation, the employee is entitled to it, even after resignation. That is, unless the company has expressly stated that continued employment is a requirement for profit sharing participation. This means the employer has a vesting requirement.
In any case, employees may be able to roll over the funds into an IRA or other retirement plan. Note that money cannot be withdrawn from a profit-sharing plan before age 59.5 without a 10% early withdrawal penalty.
Profit Sharing Plan Rollover to IRA
Those who have a profit-sharing plan through their employer can shift money from it to an individual retirement account. If the company’s plan has a vesting schedule, the person must first gain the required tenure — become vested —
before taking full ownership of the funds.
Note that individuals may transfer all or a portion of their profit-sharing balance, or even make multiple shifts. Whatever amount that is withdrawn, though, must be deposited within 60 days to avoid being taxed.
The employer must withhold 20% of the total amount, which can be reclaimed when the employee files their tax return. The employee will be subject to taxes if they fail to use their own money to replenish that 20% in the interim.
There are IRS restrictions regarding the transfer of money from profit sharing to an IRA. To wit, money may not be transferred if it results from a required minimum distribution, a hardship distribution, excess contributions, or a loan taken from the plan.
The alternative investment platform Yieldstreet offers an IRA program for investors who seek a tax-favorable and effective way to put money aside for retirement. To increase the potential for improved returns, people can add private-market investments to their retirement account. After all, it is the private market that has historically outperformed the S&P 500 in every downturn of nearly the last 20 years.
Because alternative investments are not directly correlated with public markets, they are much less volatile. From art to real estate, Yieldstreet offers a broad selection of alternative asset classes, about 85% of which are available for retirement accounts.
Yieldstreet’s IRA program supports all major accounts, meaning that people may transfer all or a portion of a traditional, SIMPLE, or SEP IRA. They may also contribute all-new funding. In addition, those with a 401(k) account or multiple retirement accounts may roll those over.
Another chief reason to add private-market assets to a retirement account is diversification. Crafting a portfolio composed of varying assets can reduce overall risk and potentially improve returns.
Footnote: Diversification does not guarantee a progit or protect against a loss in a declining market. It is a method used to help manage investment risk.
Alternative Investments and Portfolio Diversification
Alternatives can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.
Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.
In some cases, this risk can be greater than that of traditional investments.
This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million. These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform. However, that meant the potentially exceptional gains these investments presented were also limited to these groups.
To democratize these opportunities, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other distinct alternative investments.
Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10000.
Learn more about the ways Yieldstreet can help diversify and grow portfolios.
Summary
Employer profit-sharing plans can offer another way to grow their retirement savings. Note, though, that not all such plans are equal, and different plans can have varying effects on individuals’ earning prospects and tax obligations.
Note: All securities involve risk and may result in significant losses. Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information. Diversification does not ensure a profit or protect against a loss in a declining market. This tool is for informational purposes only. You should not construe any information provided here as investment advice or a recommendation, endorsement, or solicitation to buy any securities offered on Yieldstreet. Yieldstreet is not a fiduciary by virtue of any person’s use of or access to this tool. The information provided here is of a general nature and does not address the circumstances of any particular individual or entity. You alone assume the sole responsibility of evaluating the merits and risks associated with the use of this information before making any decisions based on such information.
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