Despite its name, profit sharing in a 401(k) plan doesn’t actually have much to do with your company’s profits. So what is it? Profit sharing in a 401(k) plan is actually a pre-tax contribution employers can make to their employees’ retirement accounts. The contributions are tax deductible for employers, and they’re generally made after the end of the tax year, even though they’re deductible for the prior year.
This delayed approach lets employers assess their finances at the end of the year before deciding whether they want to make a one-time contribution to each eligible employee’s 401(k) account. Employees get bonus compensation, tax-deferred, and employers get the flexibility to choose how big of a contribution they want to make (if they want to make one at all).
Why people like profit sharing
Here are six big reasons to think about offering a profit sharing plan to your employees:
1. It’s a big bonus: One way to use profit sharing is as part of employees’ year-end “bonus.” Paying such bonuses helps boost your employees’ retirement savings without increasing their taxable income in a given year. Further, profit sharing contributions are not subject to Social Security or Medicare withholding.
As a year-end bonus, a profit sharing contribution can be worth a lot more to employees than a similarly sized direct bonus payment.
2. Because hindsight is 20/20: Not sure if you want to commit to offering a potentially costly employee benefit? Profit sharing plans let you wait until the year is over to decide. Contributions are made before the tax filing deadline (including extensions) but are treated as contributions for the prior year and are deductible on that year’s tax return. In February 2020, for example, your company can make a profit sharing contribution and deduct it on its 2019 tax return.
3. Take care of HCEs: While a profit sharing plan benefits all eligible employees, it allows you to make greater contributions to Highly Compensated Employees without running afoul of IRS compliance limits for nondiscrimination testing. Profit sharing contributions are not counted toward the IRS annual deferral limit of $19,000 (in 2019). In fact, combined employer and employee contributions to each participant can be up to $56,000 (or $62,000 if an employee is over age 50).
4. An investment that can vest over time: Employers have the option of choosing a vesting schedule under which profit sharing contributions vest to the employees based on the employee's length of service. If employees leave their jobs before their contributions are fully vested, they forfeit the unvested portion. This can be an additional reward for long tenured employees, and it improves retention of newer employees.
5. Nothing’s set in stone: Profit sharing is completely discretionary, which means an employer decides annually whether or not to make a profit sharing contribution. By creating a plan, you do have to commit to a few facets of how your plan will work (more on that below), but you don’t have to commit to actually making a contribution until you’ve decided your company’s financial performance can justify it.
6. No extra work (if you offer a 401(k) already): Some 401(k) and other retirement plan providers (Like us. Hint, hint.) 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.
Allocation formulas for 401(k) profit sharing contributions
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 $10,000.
While you don’t have to decide to offer a contribution until the year is over, there’s one big thing you have to commit to in advance: How you will allocate the contribution pool between your employees. To treat all your employees fairly (and stay compliant with the powers that be), there are a few Safe Harbor methods you can use to allocate profit sharing contributions, including the ones below:
1. The comp-to-comp method - Also known as the “pro rata method,” this approach allocates the profit share based on employees’ relative salaries.
For example, if your company’s profit share was $10,000, and the total compensation of all your eligible employees added up to $200,000, here’s what it might look like:
2. Same dollar amount method – This approach (which is also called “flat dollar amount”) is a little simpler 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.
The company profit share is $3,333 per employee. The total of all eligible employee compensation is still $200,000.
Limitations to profit sharing plans
There are a few limitations that are useful to remember. Employers can only deduct contributions to retirement plans of up to 25% of total employee compensation. Further, total contributions for each participant (including employer contributions and employee deferrals) may not exceed 100% of an employee’s compensation. Total contributions to an employee are also limited to $56,000 for 2019 (or $62,000 if an employee is over age 50). Additionally, for 2019, only annual compensation up to $280,000 can be used for the calculation of any employer contribution.
Profit sharing is a great way to thank your employees for a solid effort. As part of a Guideline 401(k), we offer profit sharing plans at no added cost. Use this checklist to see if a Guideline plan is right for you.