Profit Sharing 401(k) - How it Can help Businesses Lower Taxes and More
401(k) plans provide this pretty sweet, optional feature called profit sharing. Don’t let the name fool you. It has nothing to do with whether your business earned a profit.
How does a profit sharing 401(k) work?
401(k) profit sharing allows employers to give employees including owners a discretionary contribution. The profit share contribution is typically 100% tax deductible for the firm, which can help the firm lower taxes versus other profit-sharing options the business may consider. So, if you do $100,000 in profit sharing, you likely lowered your taxable income by $100,000. The profit share also isn’t subject to Social Security or Medicare withholdings.
For you and your employees, it’s bonus with tax benefits. You boost employees' retirement accounts without increasing their taxable income. This could be worth more to employees literally and figuratively than a similar after-tax bonus.
Reward employees and lower taxes – you can see the appeal. It’s a common practice for savvy businesses to execute during years they perform well, and less so in years the business may have weaker results. You can even profit share using a vesting schedule and use it as an employee retention tool too.
You can profit-share up to 25% of an employee’s income
Employers can contribute up to 25% of an employee’s income up to the limit into their 401(k) and qualify for it to be 100% tax deductible for the business. The maximum amount an employee can receive for 2024 in a 401(k) account is $69,000 ($76,500 if 50+ years of age) including their own personal contributions.
Profit sharing can be given on a whole dollar amount where everyone gets the same, a salary percentage, or on a social security integrated basis (you’ll want to talk to a specialist like us about this – we can explain if you want to call). There are also Advanced Profit Sharing options (aka. Tiered Profit Sharing) which can help you determine different amounts or percentages by employee groups.
The most popular tends to be the same percentage, or pro rata, profit sharing. The same percentage of salary is used to determine the contributions to every employee in the firm with the monies going directly into their 401(k) account. So, let’s say you decided on a $60,000 pool, you have 5 employees including yourself, and the total compensation for you and your team is $600,000. This is a 10% of salary profit share:
Employee Salary Calculation Contribution
| Employee | Salary | Calculation | Contribution |
|---|---|---|---|
| Sarah | $200,000 | $200,000 x ($60,000 / $600,000) | $20,000 |
| Bill | $150,000 | $150,000 x ($60,000 / $600,000) | $15,000 |
| Taylor | $100,000 | $100,000 x ($60,000 / $600,000) | $10,000 |
| Mary | $75,000 | $75,000 x ($60,000 / $600,000) | $7,500 |
| Jim | $75,000 | $75,000 x ($60,000 / $600,000) | $7,500 |
Profit sharing also helps self-employed individuals save on taxes
The 401(k) profit sharing component is popular with the self-employed who have a Solo 401(k) plan. With a Solo 401(k) plan you are both the employer and employee and can contribute up to $69,000 in 2024 into your 401(k). Yes, that can drop your taxable income big time, maybe even a tax bracket.
Depending on your business entity type (sole proprietorship, LLC, or corporation), you will want to consider your saving and tax goals. Sole proprietors can typically contribute up to 20% of their net Schedule C (IRS has a formula) and most other business entities can contribute up to 25% of W-2 earnings. Keep in mind that anything contributed during the calendar year as an employee is separate from this calculation, but the employee amount still applies towards the overall contribution limit of $69,000, so don’t exceed that. Your tax advisor or accountant will be a great resource to help you finalize your approach and manage income and contribution limits.
All Businesses Have Until Their Tax Deadline to Lower Taxes for Previous Year
You have until your business tax deadline to make a profit sharing contribution for the previous year; however, you will want to decide if you will make a profit share and the amount well in advance to coordinate with your provider (e.g. first part of January typically works). Your deadline to make the actual contribution will vary by your business type. Assuming you are on a fiscal calendar year, deadlines for 2023 are:
2023 Tax Year Deadlines by Business Type
| Business | 3-15-2024 | 4-15-2024 |
|---|---|---|
| Multi-Member LLC |  |
|
| S - Corporation | |
|
| Partnership | |
|
| Sole Proprietorship | |
|
| C - Corporation | |
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| LLC | |
If you already have a 401(k) plan and think this can benefit your company, talk to your provider about how you can best use the profit sharing feature to meet your business goals.
Key Takeaways:
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Profit sharing 401(k) plans enable employers to make tax-deductible contributions to employees' retirement accounts.
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Employers can contribute up to 25% of an employee's income to their 401(k) plan, providing flexibility in structuring contributions.
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Self-employed individuals with solo 401(k) plans can utilize profit sharing to significantly reduce taxable income.
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Businesses have until their tax deadline to make profit-sharing contributions for the previous year, offering a retrospective tax-saving opportunity.
Profit sharing in 401(k) plans is a valuable tool for businesses to lower taxes while providing attractive retirement benefits to employees. By leveraging profit sharing effectively, businesses can enhance employee retention, reduce tax liability, and bolster retirement savings for all stakeholders.
This material is intended only as general information for your convenience and should not in any way be construed as investment or tax advice by ShareBuilder 401k. The owner/participant should consult with their tax advisor regarding any specific tax strategies.