Both 401(k) and profit sharing plans are employer-sponsored retirement plans.
In a profit-sharing plan, employees receive an amount from their employer based on company profits (rather than a specific amount outlined in a match formula).
All eligible employees are eligible to receive an employer discretionary profit sharing contribution.
It’s up to the employer to decide how much of its profits it wishes to contribute, and they’re capable of changing this amount.
What is a profit-sharing plan?
A profit-sharing plan is a defined contribution retirement plan that gives employees a share of the profits of their company. A profit-sharing contribution is not tied to an employee’s contribution to a retirement plan. This means all eligible employees who meet any allocation requirements defined in the plan, will receive a profit-sharing contribution.
Profit-sharing plans are flexible and allow employers to contribute when they choose, as long as contributions are substantial and recurring. An employer can make a contribution in any year, even an unprofitable year. Any profit-sharing contribution must be allocated to eligible participants using a definite, predefined allocation formula that’s stated in the plan document.
Types of Profit-Sharing Plans
There are different types of profit-sharing plans:
Stand-alone plans that only have employer profit-sharing contributions
Plans that are combined with, and part of, a 401(k) plan
Standalone profit-sharing plans
In a stand-alone profit-sharing plan, only employer contributions are permitted (i.e., an employee cannot make any contributions). This plan design may best suit small employers with limited resources that still want to offer retirement plan benefits.
If profit-sharing plans for small businesses are set up as stand-alone plans, employers can avoid the more costly, time-consuming administrative work related to maintaining a 401(k) plan.
In the future, when it has the resources, the employer can then add the 401(k) component to the plan to enhance the employer’s retirement plan offering.
Profit-sharing plans combined with a 401(k) plan
A 401(k) plan may be designed to allow an employer to make profit-sharing contributions. Rather than a stand-alone profit-sharing plan, the employer is combining the benefits of a 401(k) and a profit-sharing plan into a single plan. This can lead to cost efficiencies and a reduction of administrative burden for the employer.
This type of combined plan will have both employee elective deferrals and employer profit-sharing contributions. It may or may not have employer matching contributions as well, depending on the total investment the employer wants to make and how it wants to motivate employees with respect to retirement savings.
For many organizations, profit-sharing plans can serve as a powerful incentive for employees and owners alike. The goal of these plans is to reward all eligible employees for their contribution to the business’ success and align their financial well-being with that of the company. Because of this, profit sharing may help businesses recruit and retain employees.
Read on to learn more about if offering a profit-sharing plan is right for your organization.
Who can offer a profit-sharing plan?
Many companies are eligible to offer a profit-sharing plan, including:
Companies of any size
For-profit and nonprofit organizations (your company’s status is irrelevant)
Companies that can offer 401(k) plans (you can offer a 401(k) or a profit-sharing plan—or both)
Companies that are profitable—or not (profitability isn’t a requirement to offer this type of retirement savings plan)
A profit-sharing plan is available for a business of any size, and a company can establish one even if it already has other retirement plans. A company has a lot of flexibility in how it can implement a profit-sharing plan.
How does a profit-sharing plan work?
A profit-sharing plan is a qualified plan subject to Internal Revenue Codes (IRC) Section 401(a) and its rules and restrictions. The first step to establishing a profit-sharing plan is determining the terms of the plan via a plan document. Since a profit-sharing plan is a “qualified retirement plan,” it must also comply with all applicable rules under ERISA. The employer has plan design discretion, within set parameters, when selecting discretionary provisions.
Common types of profit-sharing plan formulas
A critical design decision for a profit-sharing plan is determining how to allocate profits among eligible employees. The IRC requires the allocation formula be stated in the plan document.
There are many permissible profit sharing allocation formulas—including age-weighted, new comparability, integrated, cross-tested, flat dollar—but the most common allocation formula is the comp-to-comp method (also called pro-rata), which is calculated using the following formula:
An employer first calculates the total of all the eligible employees’ compensation
Each employee’s annual compensation is divided by the total eligible compensation to get a percentage
The amount to be allocated to each employee is his or her percentage multiplied by the total profit sharing contribution being made to the plan
Example of a comp-to-comp (pro-rata) allocation formula
In our example, we’ll highlight a business with three employees with varying salaries. The company shares 10% of the company’s annual profit of $50,000 (this is a $5,000 profit-sharing contribution to be allocated).
|Salary/total eligible compensation||Employee’s allocation percentage x Total profit sharing contribution||Final contribution amount|
|Employee A||($50,000 / $200,000) = 25.00%||25% x $5,000||$1,250|
|Employee B||($65,000 / $200,000) = 32.50%||32.50% x $5,000||$1,625|
|Employee C||($85,000 / $200,000) = 42.50%||42.50% x $5,000||$2,125|
The first step is to add together annual compensation paid to eligible employees (e.g., $50,000 + $65,000 + $85,000 = $200,000).
Next, we divide the employee's annual compensation by the total compensation from step one to find a percentage for each employee (e.g., $50,000/$200,000 = 0.25).
Finally, we multiply this percentage by the total profit sharing contribution to be allocated ($5,000) for each employee’s final contribution amount (e.g., 0.25 x $5,000 = $1,250).
Discretionary options employers should consider when designing a profit-sharing plan
Employee eligibility: Eligibility for participation in the profit-sharing plan can be limited to employees who have worked a stated number of hours (up to 1000 hours of service in the applicable time period) or for a period of time (up to 12 months of service).
An employer can also choose to exclude non-resident aliens without U.S source income, union employees, and employees under age 21. Other exclusions based on job classification may also be possible if certain testing requirements are met.
Timing of contribution: The easiest and most common time to make a profit-sharing contribution is as a one-time, end-of-year contribution. After the plan year ends, the employer determines the amount, if any, of the profit-sharing contribution. The contribution can be put in the plan at any time until the corporate tax filing deadline (including extensions) and be counted as an allocation (and corporate tax deduction) for the previous plan year.
Loans and distributions: The plan may permit loans and/or in-service withdrawals such as hardships. The employer should review its philosophy on retirement savings when selecting these options. Some employers like to lock down distributions to ensure money is available for retirement, while others are more flexible.
Distributions: The plan must state when distributions are available and what form those distributions can be made in. Unlike 401(k) employee deferral and match contributions, profit-sharing contributions can be distributed when the employee reaches an age stated in the plan and has at least five years of service. There is a 10% penalty for early distribution if the employee is under 59 ½ unless an exception applies.
Forms of distribution an employer can select are:
Periodic or installment distributions
Ad-hoc (random) distributions
If a plan offers a lump-sum distribution, it does not have to offer any other forms of distribution. There are other rules that apply to profit-sharing plans as well including coverage testing and nondiscrimination testing.
How much can an employer contribute to a profit-sharing plan?
The maximum amount that can be contributed to a participant's account in a defined contribution plan each year is the lesser of 100% of the participant's compensation, or $66,000 for 2023 ($73,500 for a plan that includes 401(k) contributions if the employee is eligible for catch up).
Amounts included in the annual limit are any employee elective deferral contributions, employer contributions and forfeitures that are allocated to a participant's account. If an employer maintains more than one defined contribution plan, a single annual limit applies to all plans.
This means that profit-sharing contributions may be limited based on other contributions made to the plan or to other retirement plans of the same employer.
In addition, an employer’s deduction for contributions to a profit-sharing plan cannot be more than 25% of total compensation for the year for eligible employees. The maximum compensation that can be used per employee is $290,000 in 2022. (There’s a separate limit for deducting employee elective deferrals to a 401(k) plan).
Does profit-sharing count towards the 401(k) contribution limit?
No. The amount an employee can contribute to a 401(k) plan is limited by the IRC Section 402(g) limit, $22,500 in 2023 (plus $7,500 catch up for eligible employees over age 50). This limit is specific to employee elective deferrals and does not apply to any employer contributions, including profit-sharing contributions. The annual limit on total contributions for defined contribution plans, discussed above, includes any employee elective deferral contributions. 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.
Just like with other tax-advantaged retirement accounts, the IRS can change the contribution limits annually based upon cost of living adjustments. But the profit-sharing plan contribution limits give employers plenty of room to customize a plan to match their interests and their employees’ needs. There’s no set amount that must be contributed each year—but there is a maximum amount that can be contributed, which fluctuates with inflation.
Will profit-sharing reduce my company’s or my employees’ tax bills?
Yes, profit-sharing plans will help reduce your company’s and employees’ tax bills. Contributions and earnings generally aren’t included in federal or state income tax until they’re distributed. The opportunity to take a tax deduction for a profit-sharing plan contribution can be a significant benefit for growing companies. Using a profit-sharing plan to reduce the company’s income can save significant tax dollars for small business owners.
Adding a profit-sharing contribution allows the company to make larger contributions to an employee’s retirement plan account when compared to a 401(k) plan, which is limited by caps on employee elective deferrals. With a profit-sharing contribution, the employer controls the amount it contributes, but has the flexibility to contribute up to the full amount permitted by the IRS for the year.
Should I offer a profit-sharing plan to my employees?
There are several pros and cons to offering a profit-sharing plan, including whether you want or need flexibility in determining the size of the pool of money you’re going to pay out each year as well as how you might distribute money.
Pros of a profit-sharing plan:
A company can have a profit-sharing plan along with other retirement plans.
Contributions are discretionary; businesses don’t have to commit to certain dollar amounts, which can be helpful during volatile years.
A profit-sharing plan can be a good option for employers with cash flow issues.
Employers can change how much they contribute each year.
Businesses can save on corporate taxes, especially small business owners.
Plans are flexible by design.
There are NO restrictions on business size.
Profit-sharing income helps employees prepare for retirement.
Cons of a profit-sharing plan:
Profit-sharing plans are qualified plans under the IRC and require certain annual requirements, such as filing a Form 5500, providing participant notices, and conducting nondiscrimination testing.
Admin costs can be higher than other retirement plans (e.g., SIMPLE IRAs).
Stand-alone profit-sharing plans allow for employer contributions only; an employee can’t contribute.
Questions for employers to consider when setting up a profit-sharing plan
The U.S. Department of Labor provides a helpful list of questions for employers to consider when thinking about setting up a profit-sharing plan:
Have you decided to hire a financial institution or retirement plan professional to help with setting up and running the plan?
Have you adopted a written plan that includes the features you want to offer?
Have you notified eligible employees and provided them with information to help in their decision-making regarding making their 401(k) contributions?
Have you arranged a trust for the plan assets?
Have you decided how much to contribute to the plan this year?
Are you familiar with the fiduciary responsibilities?
Are you prepared to monitor the plan’s service providers?
A note on plan compliance
Compliance is an important part of running a profit-sharing plan. Having an ongoing compliance review program makes it easier to spot and correct mistakes in plan operations.
Keep in mind that to preserve the tax benefits of a profit-sharing plan, the plan must provide substantive benefits for rank-and-file employees, not just business owners and managers. Profit-sharing plans face requirements called nondiscrimination rules that compare both plan participation and contributions of highly compensated employees to nonhighly compensated employees.
If you allocate a uniform percentage of compensation to each participant, certain testing is avoided (because your plan automatically satisfies the nondiscrimination requirement). Adding a 401(k) feature to a profit-sharing plan results in additional compliance testing each year.
How can I start a profit-sharing plan?
Keep in mind that profit sharing isn’t a one-year endeavor. Plans must be established with the intention of continuing indefinitely.
1. Determine profitability
The first step to figuring out what type of 401(k) plan to offer is to make sure you’re profitable, and that you’re confident you’ll continue making money for at least the next few years. You don’t want to create and announce a plan one year, only to not be able to contribute the next!
Even though an employer isn’t required to contribute every year, contributions must be recurring and substantial. The IRS presumes contributions have been completely discontinued when the employer fails to make substantial contributions for at least three years in a five-year period. If this happens, the IRS treats the plan as terminated for vesting purposes, meaning the plan is required to make all affected employees 100% vested no later than the end of the taxable year following the taxable year in which the last substantial contribution was made.
2. Create a plan document
Once you’re ready to begin the process, it’s wise to contact legal and financial advisors who have experience creating profit-sharing plans and who can help you navigate the regulatory requirements and fiduciary responsibilities. They can help in creating a written plan document outlining the terms and day-to-day operations of the plan. The plan document must identify:
The formula you will use to calculate contributions
How contributions are deposited
How you determine employee eligibility
The vesting schedule, etc.
3. Choose a trustee
Employers need to arrange a trust for the plan’s assets. A plan’s assets must be held in a trust to ensure they’re used solely to benefit the participants and their beneficiaries. The trust must have at least one trustee to handle contributions, plan investments, and distributions. Selecting the right trustee is important, as they’ll ensure profit-sharing plans are financially secure.
4. Choose a recordkeeping system
Employers must develop a recordkeeping system to help track participants and properly attribute contributions, earnings and losses, plan investments, expenses, and benefit distributions. Most employers do not try to build a recordkeeping system of their own and instead hire a service provider (also called a recordkeeper or Third Party Adminstrator) who is responsible for these taks. A service provider will assist in preparing the plan’s annual Form 5500.
5. Contact employees
The next step is to provide plan information to eligible employees about the specific benefits, rights, and features of the plan. A Summary Plan Description (SPD), is a plain-language explanation of the plan that helps make this information clear. Any time there’s a change to the plan, all participants must receive a Summary of Material Modifications that reflects the change in the plan.
Terminating a profit-sharing plan
Profit-sharing plans must be established with the intention of being continued indefinitely into the future. Sometimes, however, an employer may need to terminate a profit-sharing plan. In this case, the plan document must be amended to terminate the plan and a final wind-down process followed. This process includes vesting all participants 100% in their account balance, conducting any final testing, making plan distributions and filing a final Form 5500. Your service provider can assist with this process.
Human Interest offers both regular 401(k)s as well as profit-sharing plans. If you’re interested in setting a profit-sharing plan up at your organization—or just have questions about plan design—feel free to reach out to our team!
Article ByThe Human Interest Team
We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment education, and integration with leading payroll providers.