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How Do Profit-Sharing Plans Work?

A 401(k) plan with a profit-sharing feature allows an employer to make contributions to their employees’ retirement accounts based on their profits.

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A profit sharing 401(k) plan is one type of competitive benefit a small business owner may offer employees to increase recruiting, retention, productivity, and overall job satisfaction.

Profit-Sharing is a feature that can be added to a normal 401(k) plan to help employees save for retirement. These plans are flexible enough to allow employers to make generous contributions when business is booming and contribute less when business is slow.

What Is a Profit Sharing 401(k) Plan?

If you offer a 401(k) plan, there are many reasons to opt to include a discretionary profit-sharing provision:

  • Profit sharing contributions are made once a year.

These additional contributions will be applied to each employee’s 401(k) account at the fiscal year’s end, depending on how well the business has performed.

  • Employees can watch their nest eggs grow.

    For instance, an employee earning $50,000 a year would receive an extra $2,500 if the employer had a five percent profit sharing allocation that year. This money will be invested and grow, with interest, for years until it is withdrawn in retirement. The compounding bonus can be a huge incentive for job seekers looking for the most competitive benefits package.

  • Employers reap generous rewards, too.

    Utilizing compensation to directly impact employees’ 401(k) balances provides an incentive for workers to give their all, as the business’s profits are their own, too.

  • Profit sharing 401(k) plans are tax-advantaged.

Unlike cash bonuses, profit sharing contributions are deposited directly into employees’ individual 401(k) retirement accounts. This matters because cash bonuses would be subject to a larger federal tax witholding. By contrast, a 401(k) profit share is not taxed until it is taken out at retirement time and taxed as regular income. Employers can count profit sharing contributions as an allowable business deduction.

  • Profit sharing 401(k)s are fairly distributed amongst all employees.

All eligible employees will receive this benefit. Generally speaking, a 401(k) profit share applies to any employee over 21 years of age who worked at least 1,000 hours in a previous year. If an employee does not participate in your 401(k) program, an account will be created for the sole purpose of allocating the profit-sharing retirement contribution.

  • Profit shares are highly flexible.

A profit sharing 401(k) benefits a mix of rank-and-file employees and key executives, but employers retain ultimate flexibility with their contributions. They can keep contributions the same for all employees, raising or lowering the percentage, depending on the year’s profits. Or they may also break employees into different groups with different contribution percentages to offer a greater share of profits to top executives and owners if desired. Employers may choose to make employees eligible on day one, or they may set eligibility requirements, meaning that employees do not become eligible to receive the benefit until they have been employed with the company for one year. Vesting requirements may also be set which could require the eligible employee to work for up to 6 years to become fully vested in their Profit Sharing account

How Does Profit Sharing Work in a Small Business?

Consider this example of profit sharing in a small business to see how employees and employer benefits.

How Small Business Profit Sharing Benefits Small Business Employees

Profit-sharing plans are based on individual salaries. So, after a great year in 2021, ABC Corp. decides to contribute a 20% 401(k) profit share to all employees. They make a $6,000 contribution to AJ (who earns $30,000), a $10,000 profit share to Beth (who earns $50,000), a $20,000 profit share to Christine (who earns $100,000), and a $50,000 profit share to owner Dan (who earns $250,000).

Best of all, the money contributed may grow through investment vehicles such as stocks, bonds, and mutual funds – untaxed – with compounding interest for years to come. If AJ is 21 and receives $6,000 a year, it could be worth over $1.1 million by age 60 (assuming y-o-y growth of 7%.)

AJ, Beth, Christine, and Dan can elect to take the money earned out starting at age 59.5 if desired, at which point they will be taxed on the amount withdrawn from the account. They can access the money earlier, but the IRS may charge an additional 10% penalty.

How Small Business Profit Sharing Benefits Small Business Owners

Of course, the profit sharing benefits aren’t just for employees. In this example, ABC Corp. will not only reward hard workers for a fantastic year to ensure they keep working hard, but they’ll also lower their taxable income for the year by $86,000 as a contribution write-off. Since profit sharing is not a payroll item, ABC Corp. won’t owe payroll, social security, or Medicare tax on that amount either.

Furthermore, polls consistently show that retirement planning assistance is one of the most attractive benefits to job seekers. If ABC Corp. operates in an industry with high turnover, attaching a 401(k) plan vesting schedule can make it more likely the workers will stay with the company, as they’ll undoubtedly want to keep all the money ABC Corp. generously contributed to their 401(k) accounts.

Profit Sharing Plan Contribution Limits in 2021

The maximum 401(k) profit-sharing contribution allowed changes each year, according to IRS adjustments. In 2021, the maximum 401k profit-sharing contribution (including the profit share) is the lesser of:

  • 100% of the participant’s annual compensation, or
  • $58,000 for employees under 50 or $64,500 for employees 50 and over.
  • The profit share potion cannot be more than 25% of compensation paid during the year.
  • The total amount of employer/employee contributions cannot be calculated on individual compensation exceeding $290,000.

How to Do Profit Sharing in a Small Business

Setting up a new profit sharing 401(k) plan for your small business is easy and affordable with a partner like Ubiquity. We’ll administer the plan and make sure you’re making fair contributions to all employees, staying within maximum contribution limits, and filing Form 5500 annually, as required by law. We’ll also help you set up terms for contributions, enroll newly eligible employees, and pay retirees their distributions.

Ubiquity makes small business 401(k)s easy to administer and maintain. We charge a low, flat, monthly fee that never increases, even as your account balance grows or you add more participants. Contact us today to get started.

© 2021 Ubiquity Retirement + Savings
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44 Montgomery Street, Suite 3060
San Francisco, CA 94104
Support: 855.401.4357

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© 2021 Ubiquity Retirement + Savings
Privacy Policy
44 Montgomery Street, Suite 3060
San Francisco, CA 94104
Support: 855.401.4357

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