Profit sharing in a 401(k) plan allows employers to make discretionary contributions to employees’ retirement accounts. These contributions are tax-deductible for the business and don’t require showing a profit. Using profit sharing helps companies reward employees, support long-term savings, and manage compensation in a tax-efficient way.
How Does Profit Sharing in a 401(k) Work?
The 401(k) profit sharing employer contributions are 100% tax deductible up to 25% of total compensation of the entire company.* These contributions aren’t subject to Social Security or Medicare taxes, creating an efficient tax-saving structure for businesses and employees. If you do $100,000 in profit sharing, you’ve likely lowered your taxable income by that same amount.
For you and your employees, it’s a 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.
Tax Advantages of Profit Sharing vs Awarding a Bonus
| Item | Profit Sharing | Bonus |
|---|---|---|
| 1. Is an added labor & benefits expense that lowers net income of the business and therefore taxes? | Yes - cost of labor expense lowers net income/taxes. | Yes - same. |
| 2. Is a tax deductible expense for the business? | Yes - can be deducted, typically by 100% of the amount.1 | Yes - if ordinary, necessary, and a reasonable amount. Cannot be viewed as a gift. |
| 3. Is tax-deferred and offers lower personal taxable means for employees, including owners and C-Level personnel? | Yes – is awarded pre-tax to employees ensuring no additional tax burden for individuals this year. No Social Security or Medicare amount is withheld either. | No - Typically 22% will be withheld on bonuses plus Social Security and Medicare rates. |
| 4. Is available to spend now? | No. You generally can’t access these funds without penalty until age 59½.1 | Yes – like any paycheck, it’s available the day it clears at your bank. |
1Assets withdrawn before age 59 ½ may incur a 10% tax penalty.
Profit Sharing Example for a 10-Employee Business
Let’s look at how the tax difference impacts the business and a C-level individual. Let’s say the company is a C-Corp of 10 employees and has $69,000 in profits to distribute to the team. In offering a bonus or profit share, this amount will be added to your labor & benefits expense. So, at a 21% corporate tax rate, this lowers net income by $69,000 and saves $14,490 in taxes ($69,000 * 21% = $14,490).
For profit sharing, the most popular form 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, and that money then goes directly into their 401(k)/profit sharing account. In this 10%-for-everyone example, your company pays $690,000 in total compensation for the entire team. There’s a $69,000 profit award pool for 10 total employees (including yourself). Here's how that breaks down:
| Group | Payroll | Calculation | Contribution |
|---|---|---|---|
| 1 Owner | $150,000 | $150,000 x ($69,000 / $690,000) | $15,000 |
| 9 Employees | $540,000 | $540,000 x ($69,000 / $690,000) | $54,000 ($6,000 each) |
Company Tax Benefit
| Tax Rate | Tax Savings | Net After-Tax Cost |
|---|---|---|
| 21% | $69,000 × 21% = $14,490 | $69,000 − $14,490 = $54,510 |
In the simple 10%-for-everyone example, $69,000 of company profit is distributed through the 401(k). This amount is tax-deductible to the company and does not count as taxable income to employees until withdrawn at retirement.
The Profit-Sharing Amount Can Double In 10 Years and Quadruple in 20 Years
The $15,000 received by the business owner in profit sharing has the opportunity to grow tax-free until withdrawn in retirement. Using the Rule of 72 and assuming a 7% annual return, $15,000 would double to $30,000 in 10 years and could grow to $60,000 in 20 years. And remember, another benefit of investing in a tax-deferred account, is that dividends, interest, and capital gains are not taxed while in the account versus using a general investing account.
How Profit Sharing Helps Business Owners Save on Taxes
Using this example of a $15,000 award, the CEO would net about $10,552 after taxes from a $15,000 bonus, versus the full $15,000 in a profit sharing contribution:
| Item | Profit Share Taxes2 | Bonus Taxes2 | Personal Tax Saving Advantage of Profit Sharing vs Bonus |
|---|---|---|---|
| Current Year Federal Income Tax | $0 – no taxes | $3,300 in taxes (22%) | $3,300 |
| Medicare Withholding | $0 – no withholding requirement | $218 (1.45%) | $218 |
| Social Security Tax | $0 - no social security tax | $930 (6.2%) | $930 |
| Total | $0 | $4,448 | $4,448 - CEO receives $10,552 (after taxes) of the $15,000 bonus |
2CEO’s tax saving amount is calculated based on the 2025 tax schedule for married filing jointly for income of $150,000 - one receiving $15,000 in profit sharing and one with a $15,000 bonus. Actual tax savings will vary based on your earnings, tax schedule/brackets, and other deductions or credits you may qualify for.
How Profit Sharing Helps the Self-Employed Save on Taxes
The 401(k) profit sharing component is also 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 the maximum contribution limit into your 401(k). That could make a big dent in your taxable income, and maybe help you drop 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 (the IRS provides resources for this), 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 your overall maximum contribution limit. Your tax advisor or accountant will be a great resource to help you finalize your approach and manage income and contribution limits.
Profit Sharing Contribution Deadlines
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.
When to Add Profit Sharing vs an Employer Match
| Goal or Situation | Use Profit Sharing | Use Employer Match |
|---|---|---|
| Encourage employee saving | Doesn’t require employees to contribute | Match motivates employees to contribute |
| Reward employees for strong company performance | Flexible — can be added in profitable years | Match is ongoing, not tied to profits |
| Maximize owner and leadership retirement savings | Can add up to 25% of comp (up to IRS limits) for owners | Limited to employee deferral + match |
| Reduce taxable income in a high-profit year | Larger deductible contribution lowers company taxes | Limited tax impact |
| Retain and reward staff across all levels | Excellent tool for retention; can reward tenure or key roles | Easy-to-understand incentive |
Profit sharing and employer matching are two powerful tools to motivate your team and improve retention. When your business has extra cash flow, profit sharing rewards all eligible employees while lowering taxes and building long-term savings. Employer matching provides a steady, easy-to-understand benefit that keeps employees engaged in saving for retirement. And if you can do both, it’s a win for your employees and your bottom line.
401(k) Contribution Comparison: Profit Sharing vs. Employer Match vs. Safe Harbor
| Feature | Profit Sharing | Employer Match | Safe Harbor Match |
|---|---|---|---|
| When it’s given | At employer’s discretion, usually annually | Each payroll or year-end | Each payroll or year-end (required annually if plan uses Safe Harbor) |
| Typical formula | % of pay (e.g., 5–10%), same for all or weighted by role/age | % match of employee deferral | Safe Harbor Match or nonelective |
| Employer flexibility | High, can change yearly | Moderate, can adjust but employees expect consistency | Low, must be funded to keep Safe Harbor status |
| Helps pass IRS nondiscrimination testing | No (testing applies) | No (testing applies) | Automatically passes testing |
| Tax deduction for company | Yes, deductible as a business expense | Yes | Yes |
| Vesting options | Flexible (can use graded or cliff) | Flexible | Must be 100% immediately vested |
| Best for companies that... | Want flexibility, tax deductions, and owner-focused savings | Want to encourage employee saving with moderate cost | Want simplicity, automatic IRS compliance, and employee goodwill |
If we add Safe Harbor contributions to the mix, you can see that profit sharing still serves as a tool to reward eligible employees while lowering taxable income. However, Safe Harbor contributions, as compared to regular employer matching, ensures that a company’s 401(k) automatically satisfies IRS compliance testing requirements and encourages employee contributions with a simple formula.
Other Profit Sharing Insights
Profit sharing can be structured in several ways—by flat dollar amount, salary percentage, or advanced tiered designs. Speak with a plan specialist to determine the best approach for your team. There are also Advanced Profit Sharing options (aka Tiered Profit Sharing) which can help you determine different amounts or percentages by employee groups.
Conclusion
Profit sharing in a 401(k) plan is a powerful tool for small businesses to lower taxes while offering meaningful retirement benefits. Used strategically, it can enhance employee retention, reduce tax liability, and grow savings for both owners and staff.
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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Typically, employer contributions are 100% tax deductible up to 25% of total compensation of the entire company.
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Profit sharing contributions are not subject to Social Security or Medicare taxes.
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Business owners (including self-employed individuals) can utilize profit sharing to 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.
*Employer 401(k) and profit sharing contributions are 100% deductible up to 25% of total compensation of all employees. So, a company paying $600,000 in total compensation can deduct up to $150,000 in taxes for the year. Please consult with your tax advisor about your company’s situation.