Types of Profit Sharing Plans

Small businesses choose to add profit sharing plans to their 401(k) because they want to contribute to employee retirement accounts, but also want to control these contributions based on how well their business did in the year. Let’s take a look at some of the other reasons to add profit sharing to your company's 401(k), as well as some of the considerations to make and steps to take if you decide a profit sharing option might be right for your business.

What Is Profit Sharing?

Profit sharing is a way for an employer to contribute some of their profits to their employees. Employers commonly combine profit sharing with an employer-sponsored retirement plan. In this blog, we are focusing only on 401(k) profit sharing plans.

What Is A 401(k) Profit Sharing Plan?

A 401(k) plan with profit sharing adds an extra feature that allows an employer to make contributions to their employees’ 401(k) accounts based on their profits. Unlike a 401(k) with “employer match,” which requires employers to match employee savings up to a certain percentage of their salary, profit sharing allows an employer the flexibility to choose how much money—if any at all—to contribute each year.

The 401(k) portion of the plan is in many ways just like any other 401(k) plan: Employees who enroll in the plan get an account where they can set aside a portion of their paycheck. That money comes out pre-tax and is then invested into cash, bonds, and mutual funds in order to grow over time and help the employee save for retirement.

How Do Profit Sharing 401(k) Plans Work?

Profit sharing 401(k) plans work like this: A business sets aside a portion of its pre-tax profits to contribute to their employees’ retirement accounts. Business owners can award that money to their employees as a percentage of their salary or as a set dollar amount. For profit sharing 401(k) plans, the yearly contribution limit is $69,000 per employee ($76,500 for age 50 and older)  or 100% of their salary, whichever amount is lower. Profit sharing can be added to a 401(k) plan with a simple plan amendment.

Types of Profit Sharing Plans

There are three primary types of profit sharing plans: the pro-rata plan (the most common), new comparability plans (the most flexible), and age-weighted plans (most helpful for retaining talent). By thinking about profit sharing contributions in terms of employee age, importance to your company, and your business goals, you can choose the one that will work best for your business. Here are the details of each:

A Pro-Rata Plan:

A pro-rata plan is one where everybody in the plan receives employer contributions at the same rate. It works similarly to an employer match, in that every employee receives a percentage—in this case, the same percentage for each employee—of their compensation as an employer contribution. For employers who want simplicity, but are interested in adding an additional benefit, this is a great choice.

New Comparability 401(k) Profit Sharing:

New comparability profit sharing (sometimes called “cross-testing”) offers the most flexibility for owners who want to personally receive the maximum possible contribution, or who want to be able to make contributions to employees at different rates. By placing employees into separate benefit groups, owners can get the maximum percentage contribution while other employees get a smaller amount. Generally speaking, cross-testing works best with older owners and a younger employee base.

Age-Weighted Profit Sharing Plans:

Age-weighted profit sharing plans feature contributions that correspond to equivalent benefits at retirement age. In other words, the older an employee is, the higher percentage contribution they’ll receive. This is a good option for employers primarily concerned with retaining talent; the longer someone stays with the company, the more their employer contribution rate will increase.

Benefits Of 401(k) and Profit Sharing

Why Employers Like Profit Sharing

• Control 401(k) Costs. The amount you contribute is completely up to you, so you have the ability to do what makes the most sense for your business. You can also divide employees into distinct eligibility groups, giving you the flexibility to contribute at different rates for different sets of employees based on a pre-determined allocation formula.
• Add Profit Sharing to Attract and Retain Talent. The average employer contribution in a profit sharing plan is 4.7% of an employee’s salary.¹Using this as a baseline, you can choose to give certain employee groups a higher contribution rate in order to attract and retain top talent. Additionally, just like with a traditional small business 401(k) plan, you can set up your vesting schedule to determine how long an employee must work for your company before they own 100% of the profit sharing contributions you make.
• Lower your Tax Liability. As with other types of 401(k) plans, all your contributions to a 401(k) plan with profit sharing plan are tax deductible. However, if you’re looking to lower your small business’ taxable income in more profitable years, profit sharing 401(k) plans can help you make the highest possible contributions to get the highest possible write-off. That’s because these plans have a much higher maximum employer contribution limit: In 2024, it’s $69,000 per year (or $76,500 for employees over the age of 50), or 100% of the employee’s total income, whichever is lower.

Why Employees Like Profit Sharing

• Save More for Retirement. Employees like profit sharing because their employer is contributing money to their retirement. American employees know they are underprepared for retirement. In fact, 46% of American workers not yet in retirement believe they will not have enough money saved to maintain a comfortable lifestyle when they do retire.²A 401(k) plan of any kind gives them an employer-sponsored way to easily save and invest in order to maintain their standard of living in retirement, especially when it’s backed by the educational support employees need to make good saving decisions.
• Get Rewarded for Hard Work. Employees know their work can make all the difference in helping their employers reach profitability. By sharing your profits with your employees with a profit sharing 401(k) plan, you are giving them a direct incentive to work harder and keep the company in the black.

Profit Sharing Plan Rules

401(k) plans with profit sharing have some key rules for maximum contributions, tax deduction limits, reporting, and timing:³

• Total Contribution Limits: Employers can only contribute up to 100% of an employee's compensation, or up to $69,000 ($76,500 for age 50 and older) as of 2024, whichever is lower.
• Calculation Rules: When calculating a single employee’s profit sharing contribution, only compensation up to $345,000 per year can be considered; more than that would increase total contributions beyond the $69,000/$76,500 annual limit.
• Tax Deduction Limits: Employers can deduct profit sharing contributions from their taxes up to maximum contribution limits.
• Disclosures and Forms: As with many other 401(k) plans, employers are required to issue disclosures to employees and anyone else who participates in a 401(k) profit sharing plan. Additionally, the form 5500 must be filed with the Department of Labor annually.
• Funding Deadline: All employer contributions to a profit sharing plan have an annual funding deadline of April 15 (unless an extension is filed). Review our 2024 compliance calendar for more information on funding deadlines.

401(k) v. Profit Sharing

401(k) plans are usually used in conjunction with a profit sharing plan, because they provide complementary benefits to the business. A 401(k) plan allows employees to save their own money into the plan—up to $23,000 per year. A profit sharing plan allows employers to contribute up to $69,000 (or $76,500 for age 50 and older) per year into employee accounts—but employees cannot make their own contributions with a profit sharing plan alone. Combining the two allows for both employee and employer contributions, creates flexibility for employee bonus structures, and allows the business owner to save more.

Keep in mind that there are pros and cons to adding a profit sharing plan to your 401(k). For example, there could be fluctuations from year to year in terms of profitability, which could make it tough on morale if employees get a lower compensation than expected. Talk to your provider about these and any other drawbacks, and ask if the advantages of profit sharing outweigh the disadvantages for your business.

How to Set Up A Profit Sharing Plan As Part Of Your 401(k)

Setting up a profit sharing plan as part of your 401(k) can be as easy as adding an amendment to your plan document, but a good profit sharing plan requires some planning. The best profit sharing plans align with a company’s goals to make Profit Sharing and 401(k) plan administration easier into the future. Plan well, think through your vision for the future of your plan and company, and find a trustworthy partner to establish a profit sharing 401(k) plan that gives employees a real benefit, as well as an incentive to give you their very best work as your company continues to grow and thrive.

¹https://www.betterup.com/blog/401k-employer-match

²https://www.stlouisfed.org/open-vault/2018/august/ready-retirement-question-nags-america

³https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits