When your company has extra profits or cash, and you want to both reward employees, including owners and/or C-level employees, and do it in a tax-efficient manner, using the profit-sharing component of your 401(k) plan can be a great way to go versus awarding more to bonuses. FYI, contrary to what the profit sharing name suggests, your business does not need to show a profit to use it.
How Does Profit Sharing in a 401(k) Work?
Profit sharing allows employers to make discretionary contributions to employee retirement accounts, including their own if they’re also employees. Typically, employer contributions are 100% tax deductible up to 25% of total compensation of the entire company.1 Most companies’ employer contributions aren’t close to exceeding the 25% of the total compensation threshold. Additionally, these contributions aren’t subject to Social Security or Medicare taxes, creating an efficient tax-saving structure for businesses and employees.
How Do the Tax Advantages of Profit Sharing Compare Versus 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 – unless you are retirement age, it won’t be available until you reach 59½ years of age. | Yes – like any bonus, it’s available the day it clears at your bank. |
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 five employees and has $60,000 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 21% corporate tax rate, this lowers net income by $60,000K and saves $12,600 in taxes ($60,000 * 21% = $12,600).
For profit sharing, the most popular form tends to be the same percentage, or pro rata, profit sharing (more insights later in this article on other options). 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)/profit sharing account. As mentioned, this is a $60,000 award pool and you have 5 employees including yourself. 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 |
Personal Tax Savings Advantage of Profit Sharing vs a Bonus
In this example, Sarah is the CEO earning $200,000 per year. If she takes the standard deduction of $29,200 on her personal taxes, $170,800 of her earnings would be taxable which equates to a 15% tax rate, or $30,466.
If she received the $20,000 as a bonus, her effective tax rate would move to 16% and she pays $34,866 in taxes, or $4,400 more this year than if it was deposited into her retirement plan. Note, the firm will withhold 22% of the bonus, but the amount over 16% will go towards here actual tax payments for the year. Medicare will also be withheld, but no more Social Security will be withheld as she’s already earned more than the Social Security taxable maximum.
The Profit-Sharing Amount Can Double In 10 Years and Quadruple in 20 Years
In addition, the $20,000 Sarah received in profit sharing has the opportunity to grow tax-free until withdrawn in retirement. Using the Rule of 72, and assuming a market return of 7% annually for the period, the $20,000 would double to $40,000 in 10 years. If Sarah is only 40, this money could double again by the time she is 60 to $80,000 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.
CEO’s Personal Tax Savings for the Current Year
Using this example of a $20,000 award to the CEO, the amount saved in personal taxes is notable:
Item | Profit Share Taxes | Bonus Taxes | Personal Tax Saving Advantage of Profit Sharing vs Bonus |
---|---|---|---|
Additional Current Year Taxes2 | $0 – no added taxes | $4,400 increase in taxes | $4,400 |
Medicare Withholding | $0 – no withholding requirement | $290 | $290 |
Total | $0 | $4,690 | $4,690 - Sarah receives $15,310 (after taxes) of the $20,000 bonus |
As you can see, profit sharing is a pretty powerful means to keep personal taxes in check this year, and perhaps as or more important, help individuals build wealth for retirement.
Other Profit Sharing Insights
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. This could restrict a high earner from receiving all the tax benefits.
There are several ways for profit sharing to be offered. It can be given as 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.
Key Takeaways:
- Profit sharing 401(k) plans enable employers to make tax-deductible contributions to employees' retirement accounts.
- Typically, employer contributions are 100% tax deductible up to 25% of total compensation of the entire company.
- Profit sharing contributions are not subject to Social Security or Medicare taxes.
- Business owners (including self-employed individuals) can utilize profit sharing to reduce taxable income.
1Employer 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.
2CEO’s tax saving amount is calculated based on the 2024 tax schedule for married filing jointly for income of $220,000 - one receiving $20,000 in profit sharing and one with a $20,000 bonus. Actual tax savings will vary based on your earnings, tax schedule/brackets, and other deductions or credits you may qualify.
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.