401(k) Profit Sharing: What You Need to Know as a Small Business Owner

As tax time approaches each year, small business owners often begin scrambling to find ways to decrease their annual corporate taxable income—sometimes resorting to making large purchases to write off as a business expense or even adding employee benefits, like a retirement plan, to their benefits package. And lately, profit sharing has become a hot topic in the industry.

Profit sharing seems to become more and more buzzworthy at the start of every year—after the fiscal year has concluded but before businesses are required to file their corporate taxes. But profit sharing plans are subject to legal regulations, so before deciding whether to offer the benefit this year, small business owners will want to make sure they are familiar with the ins and outs of 401(k) profit sharing.

What is 401(k) profit sharing?

Let's start with the basics. According to the U.S. Department of Labor (DOL), profit sharing is defined as "a type of plan that gives employers flexibility in designing key features. It allows [the employer] to choose how much to contribute to the plan (out of profits or otherwise) each year, including making no contribution for the year."¹

Put a little more plainly, profit sharing is essentially a discretionary contribution employers can elect to make to employees’ accounts at the end of the year. It is somewhat similar to an employer discretionary match in a 401(k) plan, although the amount shared with employees is usually based on each individual employee’s salary or level within the organization—but we’ll cover this in more detail later.

In its most basic of definitions, 401(k) profit sharing allows employers to choose whether or not to add additional contributions to employees’ retirement accounts after a successful fiscal year. While both can be discretionary or fixed, the key difference is whether or not the participant has to make a contribution of their own in order to receive the employer’s contribution.

But why would an employer want to share a portion of the company’s yearly profits among employees to share rather than keep it as profit? There are actually many benefits and reasons for doing so.

Benefits of profit sharing for employers

When businesses implement a profit sharing plan in their organization, they’re showing their employees that they were a critical component to the company’s success and want to reward them for their hard work by adding some extra money into their 401(k). And while this may seem like the benefit is specific to the employees, in reality, the employer enjoys many benefits as well, including:

Flexibility

Profit sharing plans provide ultimate flexibility for the business owner, allowing the employer to make the plan as simple or complex as they want. Business owners can set eligibility requirements and vesting schedules, determine distribution triggers, decide if the plan allow for loans, and elect how much to contribute to employees—or whether to make a contribution at all.

Once the profit sharing contribution is deposited into the plan, it is divided among the participants according to the allocation method chosen in the plan document. The most common is pro-rata, where each participant shares in the profit sharing contribution based on the ratio of their compensation to the total compensation of all participants. For example, simply electing to give everyone the same percent of their pay—say three percent. Another popular technique that works in certain situations is to divide the employees into groups and then allocate specific amounts to each group. If this method is used, the groups must be defined ahead of time in the plan document. Additional methods include giving all employees a flat dollar amount—for example, everyone gets $1,000—or integrating Social Security.

Tax-friendliness

Similar to other retirement savings vehicles, like 401(k) plans, employer contributions to a profit sharing plan are tax-deductible for the company for the year in which they are made. That being said, you didn’t need to have made a profit sharing contribution by December 31 for that calendar year just to capitalize on the tax advantages of profit sharing; businesses have until the tax return due date, plus extension, to contribute profit sharing funds to the 401(k) plan for the previous year. For example, if the fiscal year is the calendar year, the deadline for partnerships and S-corps would be March 15 and the deadline for sole proprietorships and C-corps would be April 15.

This gives business owners a chance to review yearly profits, determine whether or not to utilize profit sharing, and decrease the company’s taxable income all before filling annual business taxes.

Plus, since earnings in profit sharing plans generally aren’t taxed by Federal or state governments until the funds are withdrawn, business owners are gaining tax advantages on an individual level as well. Additionally, small plans may qualify for a tax credit for employer contributions for the first five years.

You might also be interested in: Year-end Tax Benefits of 401(k) Plans

Attracting and retaining talented employees

Think a profit sharing plan won’t (or can’t) attract and retain talented employees? Think again—82 percent of workers agree that retirement benefits offered by a prospective employer are a major factor in their final decision when job hunting.²

It’s no secret that today’s workers expect help from their employers with preparing for retirement, and adding an extra boost into their 401(k) account at the end of the year goes a long way in showing employees that you not only care about their financial future and livelihood, but you’re also willing to go above and beyond to help them become more retirement ready.

Utilizing a profit sharing plan to help employees save for retirement

As mentioned, utilizing a 401(k) profit sharing plan can help employees reach maximum retirement readiness—in part because, unlike an employer match in a 401(k), employees don’t need to be contributing to their retirement account to earn the profit sharing contribution. Depending on the eligibility requirements you set as the employer, all employees can receive a profit sharing allocation even if they are not making 401(k) contributions. This is especially helpful for lower earners who may not make enough to feel like they can comfortably put away a portion of their paycheck for retirement savings—giving them, essentially, an automatic boost in their retirement account.

How to know if you should offer a profit sharing 401(k)

Clearly, there are benefits to offering a profit sharing 401(k) plan. But knowing whether or not it makes sense for your small business to do so is an entirely different story.

Profit sharing plans are a great option for start-up companies and small businesses that have erratic profitability because contributions are discretionary. Made a ton of revenue and had large profit margins this year? Go ahead and celebrate with employees by offering a flat dollar amount profit sharing bonus. On the flipside, if next year you have a down year and can’t afford to spend any more money at year-end, profit sharing gives you the power to choose not to contribute.

Companies looking to save on corporate taxes at year-end or those that want to reward employees for making a positive impact on the business’s overall bottom line may also want to consider profit sharing options. As we mentioned earlier, there are certain tax advantages to offering profit sharing, and employees will undoubtedly appreciate the boost in their 401(k) savings. Plus, it reminds employees that they’re all working toward the same goal and gives them a vested interest in helping the company succeed.

It’s important to note, however, that some employers may not want to use the most flexible types of profit sharing plans. Plans must pass non-discrimination testing on a yearly basis, which are designed to level the playing field between contributions for highly compensated employees and rank-and-file employees. Make sure to review and compare potential plan designs and results before signing the plan document to help ensure your plan passes non-discrimination testing.

You might also be interested in: Is a Safe Harbor Plan Right for Your Small Business?

How to structure profit sharing at year-end

When setting up your profit sharing plan, there are a variety of decisions you’ll have to make. First, and perhaps most importantly, you’ll need to determine the method you’ll use to allocate contributions to each employee. There are a variety of methods for doing this, but it’s important to remember that the method you use cannot favor highly compensated employees over other employees, or your plan will be out of compliance. It’s important to note that the method you chose must be stated in your plan document and generally there are limited opportunities to make a change during the plan year. To determine which allocation method may be best for your small business, you’ll want to contact a trusted financial advisor or other small business retirement plan professional.

Most commonly, profit sharing contributions are a once per year lumpsum deposit into the participant’s account—usually at year-end after you’ve had a chance to evaluate business earnings and determine how much (or if at all) you’ll contribute. And to reiterate: this process doesn’t need to be completed by the end of the calendar year.

Employers have until their tax filing deadline, plus any extensions, to establish a 401(k) plan for the prior year. However, it’s important to keep in mind that a retroactive adoption of a plan like this only allows for the employer to make a profit sharing contribution for the prior year (also known as profit sharing only). This option does not allow deferrals or matching contributions for the prior plan year.

For example: Before tax filing deadlines in 2024, a business owner could adopt a plan and decrease their tax liability for 2023 by making a profit-sharing contribution to the new plan for the 2023 plan year. In 2024, the employer and employees would then be able to make deferral contributions to the plan.

It’s also important to be aware that you’ll be taking on some hefty responsibilities when you introduce a small business 401(k) profit sharing plan. If you choose to take on plan management and operation by yourself, you’ll be accountable for the essential elements of running the plan, like making timely contributions, following vesting schedules, passing non-discrimination testing, acting as a responsible fiduciary, disclosing plan information to eligible employees, distributing benefits, and filing year-end reporting—to name a few. These responsibilities are often cumbersome to the average employer, so many plan sponsors choose to hire a plan administrator to help operate their plan and stay in compliance. There are some retirement plan providers that take things a step further—helping relieve the plan sponsor of many of these responsibilities and limiting the plan sponsor’s fiduciary liability.

Profit sharing 401(k) checklist

This is a lot of complex information—there’s no doubt about that. It can be hard to determine whether profit sharing is a good option for your small business without in-depth research and vetting, but the DOL provides a helpful checklist to help employers determine if they’re ready to offer a plan that will work hand-in-hand with their 401(k).

Before deciding to offer a profit sharing plan, employers should:

Decide whether to hire a financial institution or retirement plan professional to help set up and run the plan

Determine whether to arrange a trust for the plan assets or solely utilize insurance contracts

Develop a recordkeeping system (or hire a recordkeeper)

Decide how much to contribute to the plan

Determine and understand your fiduciary responsibility as it relates to the plan

Understand the reporting and disclosure requirements of the plan

Adopt a written plan document that includes the features you’d like to offer (such as contribution allocations, eligibility requirements, vesting schedules, etc.)

Notify eligible employees and provide them with plan-related information

We know the retirement industry is not a simple one to navigate for small business owners, but you’re not in it alone. For additional help in establishing and operating a 401(k) profit sharing plan, you may want to speak with a trusted professional familiar with the ins and outs of the retirement industry.

As the nation's largest independent retirement services provider, our goal is to help more savers reach their retirement saving goals. That’s why our wide variety of retirement plan options give you the freedom and flexibility to design a plan that will fit your unique needs.

To speak with one of Ascensus’ retirement plan professionals, contact us at 800-345-6363.

Sources:

¹Profit Sharing Plans for Small Businesses, U.S. Department of Labor
² Post-Pandemic Realities: The Retirement Outlook of the Multigenerational Workforce, Transamerica Center for Retirement Studies, 2023.