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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While profit sharing plans are NOT exactly the same as 401(k) plans, there are many similarities, including that they both provide employees with additional employer compensation through tax-deferred retirement savings accounts. The money grows with compounding interest, tax-free. Employees can withdraw money at any time, but they are subject to a 10 percent IRS penalty for taking out the money before age 59.5.
Key differences include who receives the benefit, who can contribute, what incentives are driving the plans, and how much employers can deduct on their taxes.
Only eligible and participating employees can receive funds. Under the SECURE Act, eligible employees must be at least 21 years of age and have completed at least 500 hours of service per year for three consecutive years OR have served at least 12 months working full-time.
All eligible employees receive the benefit. Employees typically become eligible by working for the company at least one year, contributing to company profitability. There is no need to opt-in or out. The money is simply put into an account on behalf of each employee.
Both employees and employers may contribute to the fund. Sometimes employers agree to match what employees put in as an incentive for employees to save more. Other times, employers may opt to make a contribution even if employees aren’t actively participating in the plan.
Only employers may put money into the account. As of 2022, the maximum an employer can offer an employee in a profit sharing plan is the lesser of $61,000 or 25 percent of the employee’s total income.
The motivator is typically the employer match. The average employer 401(k) match is 4.3% of an employee’s pay. Employers may match 50-cents-on-the-dollar up to 6% of the worker’s salary, or dollar-for-dollar up to 3%, for example. Since this is essentially free money, most savers are incentivized to reserve enough to receive the maximum matching bonus.
The company’s profitability is the driving engine. Employers offer an amount based on the company’s earnings over the course of the year, with percentages generally ranging from 2.5 to 7.5 percent. If the employer does not earn a profit that year, they do not have to make contributions. Since employees do not contribute directly, they earn more money by increasing productivity and company profits.
The employer can deduct any salary paid to an employee, plus contributions made to the plan up to 100% of the employee’s compensation or a combined employee/employer maximum of $58,000 (or $64,500 for employees over 50). Employers can deduct the administrative costs of running the 401(k) as a “business expense.” They may also be eligible to receive up to $5,000/year for the first three years off the cost of administrative expenses for a new plan, as well as $1,500 over that same time period for choosing auto-enrollment as part of the plan setup.
Profit sharing contributions are also tax-deductible. Depending on how the business is organized, these deductions can flow through the business owner’s personal return. Profit-sharing contributions are not subject to Social Security or Medicare withholding, and they do not count toward the 2022 IRS deferral limit of $20,500. Combined employer/employee contributions can be up to $61,000 or $67,500. Employers can make greater contributions to Highly Compensated Employees, without failing IRS nondiscrimination testing using a profit share.
Most employers combine profit sharing and 401(k) plans to encourage employees to save, while also providing a flexible reward tied to productivity.
Businesses may choose to combine both features into one 401(k) plan or operate the plans separately. Contact Ubiquity for more information on small business retirement plans. As a small business 401(k) provider, we are committed to providing comprehensive service for a low, flat, monthly fee that stays the same, no matter how big your plan gets.