What is 401(k) Profit Sharing? What You Need to Know as a Small Business Owner

Small business owners take care of their employees in various ways. In addition to paying them a salary or hourly wage, they often provide benefits that include health insurance and employer-sponsored retirement plans such as a profit-sharing 401(k). Companies that wish to share their profits with employees can create a stand-alone profit-sharing plan or combine a profit-sharing plan with a traditional 401(k).

At CMP, our business clients rely on us to advise them on choosing retirement plans and how and whether to share profits with their employees. We’ve created this guide to help you understand how 401(k) profit-sharing plans work and how to set one up.

What is 401(k) Profit-Sharing?

A 401(k) profit-sharing plan is a traditional 401(k) plan with one key difference: employers make contributions to employees’ accounts based on their yearly profits. 

A profit-sharing 401(k) may or may not include matching contributions from the employer. As a business owner, you’ll need to decide how to calculate profit-sharing and whether you want to include matching contributions to encourage employees to save for retirement.

Can a company have a 401(k) and a profit-sharing plan? The answer is yes, and the plans may be separate or combined. Later in this post, we’ll explain how profit-sharing contributions may impact 401(k) contribution limits and taxation.

How Does 401(k) Profit-Sharing Work?

401(k) profit-sharing requires employers to calculate each employee’s share of the company’s annual profits using a formula. The calculated amount is deposited into the employee’s 401(k) according to the guidelines laid out in the profit-sharing plan document.

Employers may prefer profit-sharing to employer-matching contributions because they’ll contribute more when profits are high and less during difficult years. However, employees still get the benefit of employer contributions to augment their retirement savings.

Popular Formulas for 401(k) Profit-Sharing Contributions

Most employers who share profits with employees use one of these three methods to calculate their contributions.

1. The flat dollar amount method gives the same amount to each employee. Divide the profit you wish to share with employees by the number of employees. 
2. The pro-rata method uses each employee’s salary to calculate their profit share. To calculate your contribution, you’ll take the total amount of profits to be shared and divide it by total employee compensation to arrive at a percentage. For example, if you had $100,000 in profits to share and $1 million in total employee compensation, you would arrive at a figure of 10%. An employee earning $80,000 would receive an $8,000 contribution.
3. The new comparability method is the most complex option. Profit-sharing amounts for each employee are determined by various formulas, including EBAR (equivalent benefit accrual rates).

You can choose whichever method you wish for your profit-sharing plan. To avoid confusion, you’ll need to ensure employees understand how you calculate your contributions.

Why Do Businesses Like Profit Sharing?

Many businesses prefer a profit-sharing 401(k) for these reasons:

• Employer contributions are more flexible than employer matching plans.
• Tying employer contributions to profits can be motivational for employees.
• Employees may be more loyal to the company when they share in business profits, thus reducing employee turnover and related expenses.
• There are financial advantages because employers can deduct a portion of profit-sharing contributions when they pay their taxes.
• Employers may contribute less during years when their profits are low.

If these benefits appeal to you, you may want to consider a profit-sharing 401(k) for your small business. Keep in mind that the question of a profit-sharing plan vs. 401k doesn’t need to be an either/or proposition. You can combine both into a single plan.

Questions for Employers to Consider When Setting Up a Profit-Sharing Plan

We can’t tell you if a profit-sharing 401(k) is suitable for your company, but here are some questions to ask yourself to streamline the decision-making process.

1. Is my company reliably profitable? If the answer is yes, you may want to consider a profit-sharing 401(k). If not, it’s probably best to wait since your employees won’t get much benefit from the plan.
2. What are my objectives for profit sharing? You might want to incentivize employees to stay with your company or recruit skilled workers.
3. What do my employees think about profit-sharing? We suggest asking them to find out what motivates them and how profit-sharing might affect their lives.
4. What are my fiduciary and/or regulatory obligations? Profit-sharing 401(k) plans have their own rules, and it’s essential to understand your responsibilities before you start one.
5. Will I hire an outside administrator to manage the plan? The short answer to this question should be yes. It’s risky to administer a 401(k) plan by yourself since it could leave you open to liability issues or regulatory infractions, which is why many businesses choose to use 401k plans by a third-party administrator (TPA).

If your business is profitable, and you have a clear idea of why you want to start sharing profits and your responsibilities, then a profit-sharing 401(k) might be the right option for your company.

How Much Can an Employer Contribute to a Profit-Sharing Plan?

According to the IRS, employers may contribute up to 100% of an employee’s compensation or $69,000 to a 401(k) profit-sharing plan, whichever is lower. (The number is $76,500 for employees over 50 making catch-up contributions.)

Does Profit-Sharing Count Toward the 401(k) Contribution Limit?

One of the most common queries about 401(k) plans with profit-sharing is whether profit-sharing contributions count toward the 401(k) contribution limit. The answer depends on whether you’re an employer or an employee.

For employers, profit-sharing contributions count toward the total limit outlined in the previous section. That’s why you should consider the formula you use to calculate employees’ shares of profits and whether you also want to make matching contributions. 

Profit-sharing contributions do not count toward employees' contribution limits. To catch up on retirement savings, employees can contribute up to $23,000 for the 2024 tax year, with a catch-up contribution of $7,500 for employees 50 and over.

Will Profit-Sharing Reduce My Company’s or My Employees’ Tax Bills?

One of the looming questions for business owners is this:

Is profit-sharing taxable?

The short answer is no, not for employers. Employer contributions to profit-sharing plans are tax-deductible. If you share $200,000 in profits with your employees, you may be able to offset those contributions with a deduction of up to 25% of the compensation you paid.

The tax implications of profit-sharing are more complex for employees. 401(k) plans are tax-deferred retirement plans, meaning that employees make their contributions on a pre-tax basis and pay taxes when they withdraw funds. That rule applies to their own contributions and employer contributions, including profit-sharing.

How Can I Start a Profit-Sharing Plan?

The process of setting up a profit-sharing plan isn’t difficult. Here are the steps to follow.

1. Answer the five questions we listed above.
2. Determine your company’s profitability. (That’s included in the five questions, but you’ll need to know how much profit you have and how much you want to share before you move to the next step.)
3. Create a profit-sharing plan document that explains how you’ll calculate each employee's share of the profits and how and when contributions will be made.
4. Appoint a trustee to administer the account.
5. Choose a record-keeping system to calculate profits, track contributions, and advise employees when contributions are made.
6. Advise employees of the plan and distribute plan documents.

It’s essential to be transparent about how you will determine contribution amounts and when they’ll be made. You’ll also need to make sure that employees understand that your contributions won’t impact their maximum contribution and that whatever money they withdraw will be taxable income.

The Department of Labor (DOL) and Internal Revenue Service (IRS) provide a great deal of latitude in the design of retirement plans. You need a professional TPA retirement plan consultant who knows where the legal boundaries are. This person must also be able to advise you on which retirement plan design options will not only keep you within the boundaries set by the DOL and IRS, but will also help you achieve your own company goals in setting up and implementing a retirement plan.

Are You Ready to Set Up a 401(k) Profit Sharing Plan?

Incorporating profit-sharing with a new or existing 401(k) may help to inspire and incentivize employees and reduce employee turnover. Our guide can help you decide whether profit-sharing is right for you and take the necessary steps to set up a plan.

If you’re ready to take the next step, CMP is here to help! Our retirement planning team includes certified public accountants (CPAs) and members of the American Society of Pension Professionals and Actuaries (ASPPA). We offer the necessary expertise to create retirement plans and execute defined contribution strategies. Click the button below to schedule a consultation.