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What is 401(k) profit sharing?

What is 401(k) profit sharing?

Around the holidays, many businesses consider providing bonuses to their employees. Some businesses choose to provide their employees with a year-end bonus in a slightly more unique way than just a normal cash bonus. This is done through 401(k) profit sharing. Let’s take a look at what 401(k) profit sharing is.

What is a 401(k)?

Before we dive into 401(k) profit sharing, let’s establish what a 401(k) is. A 401(k) is a common type of retirement plan that employers can offer their employees. Traditional 401(k)s are great for any sized company that have older employees as the IRS contributions limits for both employees under and over 50 years old are greater than most other plans. While employers are not required to match employee contributions to the plan, they may wish to do so.

401(k)s do come with a greater administrative burden, such as additional paperwork and testing requirements for businesses than other types of plans.

Additionally, 401(k) plans may come with an optional feature called profit sharing.

What is 401(k) profit sharing?

401(k) profit sharing enables employers to give employees, including owners, a discretionary contribution to the employees’ 401(k) retirement plan. Each employee receives a percentage of the company profits based on the company’s earnings. There are advantages to 401(k) profit sharing for both the employee and the employer.

Employee Benefits

Offering a 401(k) profit share comes with the following benefits to the employee.

  • First, this is a year-end bonus that is in addition to their normal pay and the majority of employees appreciate bonuses given in any form.
  • Next, providing employees with a profit share can boost employee morale. Generally, happy employees result in more productivity for your business.
  • This type of bonus results in a tax savings for employees. Any contributions that are added to employees’ 401(k)s boosts employees’ retirement accounts without increasing their taxable income.
  • Finally, employer contributions via profit sharing can increase the amount that an employee is allowed to save in their retirement account on a yearly basis. IRS contribution limits for 2023 only allow employee contributions of up to $22,500, or $30,000 if over 50. However, the limits for employee plus employer contributions is $66,000. So, by offering a profit share, employees are able to potentially save a greater amount for retirement each year.

Employer Benefits

401(k) profit sharing also comes with some benefits to the employer.

  • First, bonuses, in any form, can help increase your employee engagement and retention rates. In today’s society, businesses must look for any advantage to help them attract and retain top talent. Bonuses are one type of fringe benefit that can be added to your business’ strategy.
  • Next, the profit share contribution is typically 100% tax deductible for the business. So, if you offer a total of $50,000 to all of your employees via profit sharing, your business’ tax liability will be reduced by $50,000.
  • Finally, cash bonuses given to employees are subject to FICA taxes, as well as, Federal Unemployment (FUTA) and State Unemployment (SUTA) taxes. Profit sharing contributions are not subject to these payroll taxes.

How to calculate 401(k) profit sharing

Calculating profit sharing can be done using a few different methods.

The first method is known as the same dollar or flat dollar amount method. This means all eligible employees share the total amount of the profit sharing equally regardless of the employee’s salary.

For example:

ABC Company has 3 employees. The owner of ABC decides on a $15,000 profit share using the same dollar method.

Employee Salary Profit Share Calculation Profit Share Amount Received
Joe $80,000 $15,000/3 $5,000
Bob $60,000 $15,000/3 $5,000
Jane $100,000 $15,000/3 $5,000

The second method is known as same percentage, or pro rata, profit sharing. This means that each employee gets the same percentage of their salary.

For example:

ABC Company decides on $24,000 in profit share split among their 3 employees. The total salary for the 3 employees is $240,000. Dividing $24,000 by $240,000 means that this is a 10% profit share.

Employee Salary Profit Share Calculation Profit Share Received
Joe $80,000 $80,000 x ($24,000/$240,000) $8,000
Bob $60,000 $60,000 x ($24,000/$240,000) $6,000
Jane $100,000 $100,000 x ($24,000/$240,000) $10,000
Total $240,000 $24,000