What is a Profit-Sharing Plan? - Definition, Rules & Example

Lesson Transcript
Instructor: Michael Cozad

Michael is a financial planner and has a master's degree in financial services.

This lesson will provide an overview of profit sharing plans. Many businesses across the country have implemented these plans for the benefit of their employees, so this lesson will explore the plans and provide an example of how they operate.

Overview of Profit Sharing

Retirement planning is frequently mentioned in the media. For example, several times a year, different media sources publish their version of the best companies in America to work for, and the retirement plans offered by those companies heavily influence the results. Why is this?

Saving rates in the United States are at historic lows. It's evident that Americans need all the help they can get when it comes to saving, so if the company you work for, or aspire to work for, offers a good retirement plan, it is beneficial for you and can aid in your savings for retirement.

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  • 0:00 Overview of Profit Sharing
  • 0:39 Definition of Profit…
  • 1:20 Rules and Examples
  • 4:12 Additional Rules
  • 5:49 Lesson Summary
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Definition of Profit Sharing Plan

One type of retirement plan is called a profit sharing plan. A profit sharing plan is a defined contribution plan in which your employer decides how often and how much they will deposit into the plan. That sounds a little confusing, doesn't it? Let's break down the definition. Imagine that you want to open an investment account. You get to choose how often and how much you will deposit into your account. This is similar to a profit sharing plan, except that the company gets to choose this. Going a step further, this plan is set up to help you with your retirement savings. Depending on the way the plan is set up, either you or your employer will choose how your portion of the account is invested.

Rules and Examples

Rob just graduated from college with a degree in chemistry. He was offered a job by a national chemical society, and the company has indicated to him that for 2014, they are depositing 5% of their employees' compensation into the company's profit sharing plan. Rob takes the job. '5% per year?' he thinks. 'This is great!' Rob's salary for 2014 was $40,000 so, as promised, the company deposits $2,000 into his account. The plan is not set up for Rob to contribute nor can Rob choose how his $2,000 is deposited.

In 2015, the following year, Rob is notified that the company will not be contributing to the plan. Rob is upset. He thinks he was promised 5% of his salary per year. Rob is about to lodge a complaint, but a coworker urges him to read the plan's Summary Plan Description (SPD) first. This document summarizes what is stated in the plan's Adoption Agreement and explains the rules that guide the plan. Upon reading the SPD, Rob realizes that the company has discretion each year to determine how much they will contribute to the plan. Rob wished he had read the SPD prior to taking the job, but hopes the company will make a deposit the next year.

2016 then rolls around. Rob is notified that the company will be contributing 10% of compensation. Rob is elated; 10% of $50,000 is $5,000! Rob goes about his business through the year, and in the middle of December he is notified he is being terminated. The company is downsizing. Rob has made about $47,500 through the year, so he is counting on $4,750 being deposited into his account. He gets his year-end statement and notices the company did not deposit anything to his account. Extremely frustrated and about to call human resources, he retrieves his copy of the Summary Plan Description. He reads the part about termination. It states that in order to receive a profit sharing contribution, the employee must be employed on the last day of the year. 'Those turkeys!' Rob thinks.

He keeps reading. He then notices something even more frustrating: The plan has a vesting schedule attached to the contributions made. Rob keeps reading and finds out that in order to receive 100% of the contributions the company made on his behalf, he would have had to have been employed for three full years, working 1,000 or more hours per year. This is called a three-year cliff vesting schedule. Since he was employed less than two years, he receives nothing.

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