401(k) profit sharing plans: The nuts and bolts of a great benefit
Despite its name, profit sharing in a 401(k) plan doesn’t necessarily involve your company’s profits. So what is it? Profit sharing in a 401(k) plan is a pre-tax contribution employers can make to their employees’ retirement accounts after the end of the year.
The contributions are tax-deductible for employers for the previous tax year. This delayed approach lets employers assess their finances before deciding whether or how much they want to contribute to each eligible employee’s 401(k) account.
Why businesses like profit sharing
Here are five benefits to offering a profit sharing plan:
1. It’s a bonus with tax benefits
One way to use profit sharing is as part (or all) of your employees’ year-end bonus. These bonuses boost your employees’ retirement savings without increasing their taxable income in a given year. Profit sharing contributions are also tax-deductible to the employer and aren’t subject to Social Security or Medicare withholding. As a year-end bonus, a profit sharing contribution may eventually be worth more to employees than a similarly-sized direct bonus payment.
2. The flexibility to plan your finances
Not sure if you can offer a potentially costly employee benefit? Profit sharing plans let you decide after the end of the year. Contributions must be made before the tax filing deadline (including extensions), and are still deductible on the previous year’s tax return. In February 2024, for example, your company can make a profit sharing contribution and deduct it on its 2023 tax return.
3. Take care of Highly Compensated Employees (HCEs)
A profit sharing plan may allow you to make greater contributions to HCEs without failing IRS compliance limits for nondiscrimination testing. Profit sharing contributions are not counted toward the IRS annual deferral limit.
4. A reward that can vest over time
Employers have the option to choose a contribution vesting schedule based on the employee's length of service. If employees leave the company before their contributions are fully vested, they forfeit the unvested portion. Vesting can incentivize retention, as employees receive more contributions to their 401(k) the longer they stay.
5. No extra work if you offer a 401(k) already
Some 401(k) and other retirement plan providers let you set up a plan that allows for profit sharing. That means only one fee and one benefit to manage if you set it up right.
Popular formulas for 401(k) profit sharing contributions
Along with making the decision to offer a contribution after the year is over, you will also need to determine how to allocate the contribution pool between your employees. To treat all your employees fairly (and stay compliant with the IRS), Guideline offers two design-based Safe Harbor formulas you can use to allocate profit sharing contributions, as well as one non-design-based Safe Harbor formula.
When you decide to make a contribution to your profit sharing plan, you do so by setting aside a “pool” of money that will be contributed across all your eligible employees. Let’s say you decide to contribute a total of $10,000. Here are examples of how they work with the two design-based safe harbor formulas:
Flat dollar amount method
This approach (which is also sometimes referred to as ‘same dollar amount’) is the most simple because every employee receives the same contribution amount. You calculate each eligible employee’s contribution by dividing the profit pool by the number of employees who are eligible for your company's 401(k) plan.
Example: The company profit sharing pool is $10,000 and there are three eligible employees. Each employee would get $3,333, regardless of their salaries.
The pro-rata method
Also known as the “comp-to-comp method,” this approach allocates the profit share based on employees’ relative salaries.
Example: The company profit sharing pool is $10,000, and the combined compensation of your three eligible employees is $200,000. As a result, each employee would receive a contribution equal to 5% of the employee’s salary.
A new comparability profit sharing formula may allow a greater disparity of contributions between different groups of employees. In other words, older employees with higher salaries can have greater contributions than younger employees with lower salaries. New comparability plans are not design-based safe harbors so have to pass IRS testing to prove nondiscrimination. New comparability profit sharing is generally desirable for business owners and executives who are older, make more money than other employees, and want to maximize employer contributions to their own accounts. New comparability is included in Guideline’s Enterprise tier, but may incur a fee for Core in each year it is used.¹
The first step in making a new comparability contribution is to allocate a “minimum gateway” contribution to all Non-Highly Compensated Employees (NHCEs), usually between 3 and 5% of compensation. We generally recommend that this minimum contribution be made in the form of a Safe Harbor nonelective contribution to automatically pass nondiscrimination testing.
The next step is to make differing contributions to each employee in such a way that the future retirement benefit derived at normal retirement age is equivalent.
Example: The owner of a small business is a 50 year old with a high income. Using new comparability, the owner is able to receive a larger profit sharing contribution than the younger and lower income employees.
New comparability profit sharing may be appropriate for a small business if:
- You'd like to maximize employer contributions made to owners
- Owners are generally older than non-owner employees
- Owners receive higher compensation than non-owners
- You have a small number of employees (usually fewer than 50)
Because new comparability profit sharing calculations are based off year-end employee census information, changes in personnel can significantly impact projected contributions. As such, specific results can’t be guaranteed until year-end data becomes available.
Limitations to profit sharing plans
There are a few limitations to remember when making employer contributions, such as profit sharing:
- Employers can only deduct contributions to retirement plans of up to 25% of total employee compensation.
- Total contributions for each employee (including employer contributions and employee deferrals) may not exceed 100% of the employee’s compensation.
- Total contributions to an employee are also limited to $69,000 for 2024 (or $76,500 if an employee is over age 50).²
- For 2024, only annual compensation up to $345,000 can be used for the calculation of any employer contribution.²
Profit sharing is a great way to thank your employees while being mindful of your finances. Use this checklist to see if a Guideline plan is right for you.
The information provided herein is general in nature and is for informational purposes only. It should not be used as a substitute for specific tax, legal and/or financial advice that considers all relevant facts and circumstances. You are advised to consult a qualified financial adviser or tax professional before relying on the information provided herein.
1 See our Form ADV 2A Brochure for more information on our fees.
² May be adjusted annually to account for IRS cost-of-living adjustments.