Are you wondering if a 401(k) profit-sharing plan is right for your small business? Profit-sharing plans are the most flexible type of contribution that an employer can make to a 401(k) plan. Small businesses often choose to add profit-sharing plans to their 401(k)s either to give a tax-advantaged bonus to employees, or in order for owners to contribute more than the IRS limit. We are going to cover 401(k) profit-sharing plans in depth to help you decide if it’s right for your small business.
What is a 401(k) profit-sharing plan?
A 401(k) profit-sharing plan allows an employer to set aside money each year to contribute to their employee’s 401(k) accounts based on the business profits. This provides flexibility to the employer as they can choose how much they want to contribute, if any at all, for that year.
A 401(k) and a profit-sharing plan are two separate plans that can be combined to increase contribution limits. A profit-sharing plan is different from a 401(k) plan with an employer match which requires employers to match employee savings up to a certain percentage of their salary. Profit-sharing plans are the most flexible type of contribution that an employer can make to a 401(k) plan.
A 401(k) profit-sharing plan can be a great choice for your business if you are a startup or have erratic profitability. They can also be a great choice for established businesses because you can increase the contributions made to an employee’s 401(k) account which gives low-income earners a good retirement benefit.
How does a 401(k) profit-sharing plan work?
A 401(k) profit-sharing plan gives employees a share in the profits of the company. Employers can choose to contribute a percentage of those profits to an employee’s 401(k) depending on how well the company performed that year. The contributions are tax-deductible for employers for the previous year.
First, a business will set aside a portion of its pre-tax profits to contribute to their employee’s retirement accounts. Business owners contribute a percentage of their employee’s salary or a set dollar amount. These contributions may be for the employees to keep immediately or they may be subject to a vesting schedule.
All employer contributions to a 401(k) profit-sharing plan have an annual funding deadline of April 15 (unless an extension is filed).
What is the contribution limit for 401(k) profit-sharing plans for 2023?
The yearly contribution limit for 401(k) profit-sharing plans is $66,000 per employee ($73,500 for age 50 and older) or 100% of their salary, whichever amount is lower.
What’s the difference between a 401(k) and a 401(k) profit-sharing plan?
401(k) profit-sharing plans are usually used in conjunction with a 401(k) plan.
- A 401(k) allows employees to save their own money for retirement. The contribution limit for 2023 is $22,500 per year. Employees generally receive a tax deduction for their contributions. The employer may also make a contribution and receive a tax deduction.
- With a 401(k) profit-sharing plan, an employer sets aside a proportion of total profits each year to contribute to their employee’s 401(k)s. It allows employers to contribute up to $66,000 (or $73,500 for those age 50 and older) per year into employee accounts. Only the employer contributes to the retirement account, not the employee. A 401(k) profit-sharing plan gives the employer the freedom to choose how much they want to contribute.
What are some benefits of offering a 401(k) profit-sharing plan to employees?
- It’s a bonus with tax benefits: You can use the profit sharing as your employees’ end-of-year bonus. These will boost your employees retirement savings without increasing their taxable income for that year. Profit sharing can sometimes be worth more to an employee than a direct end-of-year bonus payment.
- Flexibility on how much you want to contribute to your employees 401(k) plan: If you are not sure how much you can contribute to your employees 401(k) plan, then a profit-sharing plan may be beneficial for you. You can decide at the end of the year how much you want to contribute. Contributions must be made before the tax filing deadline and they will be tax-deductible for the previous year.
- If you already offer a 401(k) plan, then it might be free to set up: Some 401(k) plan providers can let you set up a plan that allows for profit sharing. That means that you shouldn’t have to pay any additional fees to set it up.
- Lower your tax liability: All of your contributions to a 401(k) plan are tax-deductible. If you want to lower your small business taxable income in more profitable years, then 401(k) profit-sharing plans can help you make the highest possible contributions to get the highest possible write-off.
- Boost your own 401(k): The small business owner will be able to contribute more to her 401(k) above the normal $22,500 IRS limit for 2023.
What are some drawbacks to offering a 401(k) profit-sharing plan to employees?
- The total contribution for each employee cannot exceed 100% of the employee’s compensation.
- Total contributions to an employee are also limited to $66,000 for 2023 (or $73,500 if an employee is over age 50).
- Inconsistent contributions: While employers may think that the year-to-year flexibility of contributions is good, employees may not feel the same. The unpredictability of 401(k) profit-sharing plans may be disconcerting to some employees who may have had a traditional 401(k) employer match previously.
What are the three common profit-sharing formulas?
- Pro-rata: This is when employees all receive the same contribution rate. The employer would decide on a percentage, such as 3%. All employees would then receive a contribution that is 3% of their annual salary. This allocation method will automatically pass the IRS nondiscrimination testing.
- Permitted disparity: This formula generally favors employees with a high salary. It involves two pro rata allocations to employees. One is based on their total compensation and one is based on any compensation earned above the “integration level”. The integration level is either the Security Taxable Wage Base (SSTWB) in effect for the year or some portion of it. This formula may suit your business if you want to reward high-income employees while still passing the IRS nondiscrimination test.
- New comparability: This is the most flexible formula. It allows an employer to allocate multiple contribution rates to different employee groups and even a different contribution rate to each employee. This formula is generally used if you want to reward larger contribution rates to business owners or other employees with a large salary. However, this method must pass a complicated IRS nondiscrimination test to prove they aren’t discriminating.
Does profit-sharing count towards the 401(k) contribution limit?
No. The amount an employee can contribute to a 401(k) plan is $22,500 for 2022 (plus $7,500 catch up for eligible employees over age 50). This contribution limit is specific to employee contributions and does not apply to employer 401(k) profit sharing contributions.
However, the annual limit for 401(k) profit sharing contributions includes any employee 401(k) plan contributions. Therefore, if the employer only has a stand-alone profit-sharing plan, the full limit can be used for that plan. If the employer also has a 401(k) plan, any 401(k) contributions made by employees, and any match made by the employer, count against the single limit. Therefore, profit-sharing contributions will be limited based on these other contributions.
How can I set up a 401(k) profit sharing plan for my small business?
It’s usually as easy as creating a 401(k) plan for your company and adding the 401(k) profit sharing options or making an amendment to your existing 401(k) plan.
Can my business offer a 401(k) and a profit sharing plan?
Yes. You can either offer a single plan which has both a profit sharing plan and a 401(k) plan, or you can offer them as two separate plans for retirement.
What is a typical profit sharing percentage?
The majority of experts suggest that a typical profit sharing percentage is between 2.5% and 7%.
Is a 401(k) profit sharing plan a good idea for my business?
A 401(k) profit sharing plan can be a powerful tool to help you attract and retain good talent. 401(k)s and profit sharing plans can be complex and do have a lot of rules so it’s important to discuss these options with your financial advisor before deciding how these may work for your small business.
Reward employees with a 401(k) profit sharing plan!
A 401(k) profit sharing plan is a great way to reward your employees while being mindful of your finances. If you are interested in having a comprehensive financial plan, schedule a free discovery call with one of our fee-only financial advisors today.
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.