401(k) Profit Sharing contributions can be a game-changer for many small business retirement plans. Their popularity has grown, with profit-sharing plans increasing contributions by 13%, according to one 2022 study.
Profit-sharing contributions are easy to add to 401(k) plans and can help business owners save thousands on taxes. Moreover, research suggests that profit-sharing plans can improve employee satisfaction and worker productivity.
Offering a profit-sharing plan can provide substantial tax savings for owners and employees. Employer contributions are tax-deductible, and employees can boost valuable tax-deferred 401(k) retirement savings.
A 401(k) profit-sharing plan allows employees and employers to contribute up to the 2023 401(k) contribution limits:
Employers can base their contributions on company profits, employee age, service, and employee income. Some methods even allow employers to benefit highly-compensated employees.
Despite what the name implies, a company does not need to be profitable to make “profit-sharing” contributions. Contributions are usually a percentage of an employee's salary, not the company's profits.
But the benefits go well beyond a legal tax shelter. Profit-sharing plans can significantly help companies attract and retain top talent. Savvy business owners use profit-sharing to keep employees from leaving by leveraging vesting schedules of up to six years.
Profit-sharing plan contributions fall under the umbrella of non-elective contributions. This means that employees are eligible for contributions even if they do not save in the 401(k). While they are similar to Safe Harbor Non-Elective contributions, profit-sharing has three distinct advantages:
Unlike Safe Harbor contributions, profit-sharing contributions are optional. Adding a profit-sharing feature to your plan does not obligate you to contribute. Employers can decide at the end of each year how much if any, contributions they wish to make. If business is good - contribute; if not, don't.
Another benefit is that profit-sharing plans allow vesting, which helps retain employees. Owners can customize a vesting schedule with a 3-year cliff or even graded vesting schedules of up to six years. If you want to lower employee turnover, profit sharing can help. If employees leave before they're fully vested, they might lose some or all of their contributions.
Plans can give equal amounts to each employee, equal percentage of pay or favor some employees like owners or older employees. Companies can change the plan formula each year by amending the plan or using a formula that benefits employees more.
The IRS significantly increased 401(k) profit-sharing limits from $61,000 in 2022 to $66,000 in 2023. People over age 50 can save up to $73,500 a year.
This is due to catch-up contributions of $7,500. This amount increased from a $6,500 catch-up in 2023. However, the IRS caps employer contributions at 25% of an employee's eligible pay.
Some plans may allow participants to withdraw employer profit-sharing contributions or rollover assets while working. Rolling over profit-sharing contributions to a Roth IRA effectively lets employees save up to $66,000 per year in Roth contributions.
Most employers typically fund their profit-sharing contributions after the end of the calendar year. Employers have until they file their taxes (with extensions) if they want to deduct profit-sharing contributions. This allows employers time to calculate plan-eligible compensation (which may require a K-1 for owners). We then run through various profit-sharing scenarios to help them get the most out of their tax deductions.
Profit-sharing contributions are good for companies with uncertain profits or planning to acquire other businesses.
For more stable companies, these contributions can help achieve various 401(k) plan goals, such as:
A 2022 study by Vanguard found that 46% of retirement plans had profit-sharing or ESOP features. ESOPs and profit-sharing plans let employees benefit more when the company does well, which can motivate employees. A 2016 Harvard study found that aligning individual incentives with group-based performance pay can increase loyalty and job satisfaction.
There are four common ways employers calculate 401(k) profit-sharing contributions: pro rata, permitted disparity, new comparability, and age-weighted.
Pro rata is the simplest formula for retirement plans. With this allocation, every eligible employee receives the same contribution rate (i.e., a contribution's dollar amount divided by the participant's compensation).
This formula is a straightforward, easy-to-understand benefit for employees. Moreover, since everyone gets the same benefit, pro rata profit-sharing contributions automatically pass IRS 401(k) nondiscrimination tests.
Permitted disparity profit-sharing contribution formulas are more intricate that often favor higher-income employees.
The plan calculates contributions based in two steps. In step one, the employer provides a pro-rata contribution based on employee pay. Then, in step two, the employer provides an additional retirement contribution based on pay above a certain level.
Permitted disparity formulas are worth considering if your goal is to benefit HCEs while still automatically passing IRS nondiscrimination testing.
New comparability is the most versatile type of profit-sharing allocation formula. Basically, this method allows employers to determine the employer contribution, employee by employee. While employers must pass additional nondiscrimination tests, these tests take both income and age into account. This significantly helps older owners maximize their personal tax-shelter while keeping overall plan costs minimal.
For example, imagine a small business owner looking to maximize their 401(k) salary deferral. They could choose to exclude some or all of the other HCEs. This reduces the average benefit received by HCEs as a group, and by extension, reduces the benefit needed for NHCEs.
In fact, when properly structured, a business owner may actually increase their after-tax income. For example, imagine a hypothetical small business owner Melinda with four HCEs and five young NHCEs.
By making a $10,000 profit-sharing contribution, Melinda can shelter $73,500 in income, saving $28,000 in taxes. Melinda's may now be $18,000 ahead! Employees receive a bigger benefit, owners save on taxes and the only one that might lose is the IRS.
However, new comparability allocations must pass a complex IRS nondiscrimination test (known as the "general test"). Essentially, the General Test breaks the plan down into "rate groups," or mini plans. The percentage of HCEs and NHCEs that receive the profit sharing needs to be close (70%).
Older business owners that make more than their younger NHCEs, can significantly benefit thanks to "cross-testing." Here profit-sharing 401(k) plans must satisfy the “gateway minimum.” NHCEs must receive at least one-third of the profit-sharing rate given to HCEs. Alternatively, they must receive 5% of their plan-eligible pay, whichever is lower.
In short, new-comparability 401(k) profit-sharing plans can be a powerful way to maximize tax deductions for owners. However, if the owners are relatively young, it may not be the best alternative.
Age-weighted profit-sharing allocations are a specialized contribution strategy within a company's profit-sharing plan. Age-weighted allocation formulas consider an employee's compensation, age, and years of service.
With age-weighted profit-sharing plans, older employees receive larger profit-sharing contributions, even if they have the same compensation. This helps older employees rapidly build retirement funds. It is particularly valuable when the goal is to provide substantial retirement benefits to longer-serving or older staff members.
Profit-sharing contributions are one of the most flexible ways business owners can customize a plan to meet specific goals. Employers can combine profit-sharing with traditional 401(k)'s and even Safe Harbor plans.
David Ramirez, CFA, is a recognized 401(k) expert with over 20 years of experience in 401(k), ERISA, cash balance plans, and ESOPs. A UC Berkeley graduate, he played a pivotal role at Financial Engines, a 401(k) advisory firm founded by Nobel Laureate William Sharpe, Ph.D., where he was a portfolio manager who helped manage over $50B in 401(k) assets. His clients included some of the largest Fortune 500 companies and state governments.
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