What exactly is a profit sharing contribution?
Let’s start with a profit sharing plan. This plan is a type of defined contribution plan. And a 401k plan is simply a sub-section of a Profit Sharing plan within the Internal Revenue Code (see the chart below for a visual). What this means is that your employer has the ability to make contributions to your account based on the profit it earns from its business.
In other words, a profit sharing contribution!
If your company had a good year they may decide to reward you for it by allowing you to share in its profits by giving you a portion of it in the form of a Profit Sharing contribution.
This type of 401k contribution is beneficial for all involved. You, as the employee, receive free money. You can’t complain about that! (Keep in mind that your vested percentage determines how much of your employer’s contributions you get to keep.)
It’s beneficial for your employer, too, because the contribution they make to your account is tax deductible for them. It also has a tendency to boost employee morale and create a more efficient workplace.
Happy employees = better business.
While profit sharing contributions seem pretty straight forward there are a few things to keep in mind about them:
- They are NOT required. They are considered discretionary contributions and may or may not be made to your account. And if they are made to your account, they are not required to be made every year. So, while you got one last year, don’t necessarily expect it this year.
- They are NOT necessarily based on profits. The term ‘profit sharing’ should not be construed to mean that the contribution is tied to the actual profit your employer has generated in a given year. In some cases it is. But in many others the amount your employer gives is not tied to profits at all. It’s frequently based on a relatively simple formula unrelated to profits.
- They must be distributed to ALL eligible participants. If your employer announces that a profit sharing contribution will be made, it must be given to every employee who meets the eligibility criteria (usually based on years of service). Your employer cannot discriminate in favor of certain employees while excluding others (namely the highly compensated employees).
Note: Every employee will not receive the same amount. The amount is determined by the formula your employer uses which can be based on many factors including years of service and compensation. Contact your benefits office for information on this.