General manager Adrian Hanauer made the announcement at an end-of-season media conference on Thursday.
The Sounders narrowly missed out on a spot in the MLS Cup final but inaugural coach Schmid, who took charge in the club's debut season in 2009, has been rewarded after guiding Seattle to the US Open Cup and the Supporters' Shield - awarded to the team with the best regular-season record - in 2014.
Seattle were edged by Western Conference rivals Los Angeles Galaxy on away goals last week as their search for a maiden MLS Cup title continues.
"There's nothing I want more than to bring an MLS Cup to this city and these fans," Schmid told reporters on Thursday.
"I still like being close to the bench or the locker room. More so than anything, the beauty of coaching is that no year is the same."
Schmid has won three Supporters' Shield trophies (2002, 2008, 2014) and two MLS Cups (2002, 2008) during his coaching career.
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