Like a traditional 401(k) plan, a 401(k) profit share plan is an employee benefit that can provide a vehicle for tax-free retirement savings. But the biggest difference between an employer-sponsored 401(k) and a 401(k) profit share plan is that in a profit share plan, employers have control over how much money—if any—they contribute to the employee’s account from year to year.
In other ways, the 401(k) profit-sharing plan works similarly to a traditional employer-sponsored 401(k). Under a 401(k) profit share plan, as with a regular 401(k) plan, an employee can allocate a portion of pre-tax income into a 401(k) account, up to a maximum of $19,500 per year (in 2020 and 2021).
At year’s end, employers can choose to contribute part of their profits to employee’s plans, tax-deferred. As with a traditional 401(k), maximum total contributions to an account must be the lesser of 100% of the employee’s salary or $58,000 a year per the IRS; that number jumps to $64,500 for older employees who are making catch-up contributions.
How Does 401(k) Profit Sharing Work?
There are several types of 401(k) profit-sharing setups employers can choose from. Each of these distributes funds in slightly different ways.
In this common type of plan, all employees receive employer contributions at the same rate. In other words, the employer can make the decision to contribute 3% (or any percentage they choose) of an employees compensation as an employer contribution. The amount an employer can share is capped at 25% of total employee compensation paid to participants in the plan.
New Comparability 401(k) Profit Sharing
In this plan, employers can group employees when outlining a contribution plan. For example, executives could receive a certain percentage of their compensation as contribution, while other employees could receive a different percentage. This might be an option for a small business with several owners that wish to be compensated through a profit-sharing plan.
This plan calculates percentage contributions based on retirement age. In other words, older employees will receive a greater percentage of their salary than younger employees, by birth date. This can be a way for employers to retain talent over time.
Integrated Profit Sharing
This type of plan uses Social Security (SS) taxable income levels to calculate the amount the employer shares with employees. Because Social Security benefits are only paid on compensation below a certain threshold, this method allows employers to make up for lost SS compensation to high earners, by giving them a larger cut of the profit sharing.
Pros and Cons of 401(k) Profit Sharing
There are benefits and drawbacks for both employers and employees who participate in a profit-sharing 401(k) plan.
Employer Pro: Flexibility of Employer Contributions
Flexibility with plan contribution amounts is one reason profit share plans are popular with employers. An employer can set aside a portion of their pre-tax earnings to share with employees at the end of the year. If the business doesn’t do well, they may not allocate any dollars. But if the business does do well, they can allow employees to benefit from the additional profits.
Employer Pro: Flexibility in Distributions
Profit sharing also gives employers flexibility in how they wish to distribute funds among employees, using the Pro-Rata, New Comparability, Age-Weighted, or Integrated profit sharing strategy.
Employer Pro: Lower Tax Liability
Another advantage of profit share plans is that they allow employers to lower tax liability during profitable years. A traditional employer contribution to a 401k does not have the flexibility of changing the contribution based on profits, so this strategy can help a company maintain financial liquidity during lean years and lower tax liability during profitable years.
Employee Pro: Larger Contribution Potential
Some employees might appreciate that their employer 401(k) contribution is tied to profits, as the compensation might feel like a more direct reflection of the hard work they and others put into the company. When the company succeeds, they feel the love in their contribution amounts.
Additionally, depending on the type of distribution strategy the employer utilizes, certain employees may find a profit-sharing 401(k) plan to be more lucrative than a traditional 401(k) plan. For example, an executive in a company that follows the New Compatibility approach might be pleased with the larger percentage of profits shared, versus more junior staffers.
Employee Con: Inconsistent Contributions
While employers may consider the flexibility in contributions from year to year a positive, it’s possible that employees might find that same attribute of profit sharing 401(k) plans to be a negative. The unpredictability of profit share plans can be disconcerting to some employees who may have come from an employer who had a traditional, consistent match set up.
Employee/Employer Pro: Solo 401(k) Contributions
A profit share strategy can be one way solo business owners can maximize their retirement savings. Once a solo 401(k) is set up with profit sharing, a business owner can put up to $19,000 a year into the account, plus up to 25% of net earnings, up to a total of $58,000. This retirement savings vehicle also provides flexibility from year to year, depending on profits.
Withdrawals and Taxes on 401(k) Profit Share Plans
A 401(k) with a generous profit share plan can grow quite quickly. So what about when you’re ready to take out distributions? A 401(k) withdrawal will have penalties if you withdraw funds before you’re 59 ½ (barring certain circumstances laid out by the IRS) but the money will still be taxable income once you reach retirement age. Additionally, like traditional 401(k) plans, a profit-sharing 401(k) plan has required minimum distribution requirements (RMDs) once an account holder turns 72.
Investors who anticipate being in a high tax bracket during their retirement years may consider different strategies to lower their tax liability in the future. For some, this could include converting the 401(k) into a Roth IRA. This is sometimes called a “backdoor Roth IRA” because rolling over the 401(k) does not subject an investor to the income limitations that cap Roth contributions.
An investor would need to pay taxes on the money they convert into a Roth IRA, but distributions in retirement years would not be taxed the way they would have if they were kept in a 401(k). Any 401(k) owner who qualifies for a Roth IRA can do this, but the additional funds in a 401(k) profit share account can make these moves that much more impactful in the future.
A 401(k) profit share plan allows employees to contribute pre-tax dollars to their retirement savings, as well as benefit from their employer’s profitability. But because profit share plans can take multiple forms, it’s important for employees to understand what their employer is offering. That way, employees can create a robust retirement savings strategy that works for them.
There are many retirement savings options besides an employer-sponsored 401(k) (profit-sharing or not), and some investors invest in a combination of different plans that suits their short-term and long-term needs. SoFi Invest® offers both Roth and traditional IRA accounts, both of which can help make saving for retirement easier.
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