A comprehensive guide to 401(k) profit sharing: What you need to know as a small business owner
As tax time approaches each year, small business owners often begin scrambling to find ways to decrease their annual corporate taxable income—sometimes resorting to making large purchases to write off as a business expense or even adding employee benefits, like a retirement plan, to their benefits package. And lately, profit sharing has become a hot topic in the industry.
Profit sharing seems to become more and more buzzworthy around this time every year—after the fiscal year has concluded but before businesses are required to file their corporate taxes. But profit sharing plans are subject to legal regulations, so before deciding whether to offer profit sharing this year, small business owners will want to make sure they are familiar with the ins and outs of 401(k) profit sharing.
What is 401(k) profit sharing?
Let’s start with the basics. According to the U.S. Department of Labor (DOL), profit sharing is defined as “a type of plan that gives employers flexibility in designing key features. It allows [the employer] to choose how much to contribute to the plan (out of profits or otherwise) each year, including making no contribution for the year.” 
Did you follow that?
Essentially, profit sharing is a discretionary contribution employers can elect to make to employees’ 401(k) accounts at the end of the year. It is somewhat similar to an employer discretionary match in a 401(k) plan, although the amount shared with employees is usually based on each individual employee’s salary or level within the organization—but we’ll cover this in more detail later.
In its most basic of definitions, 401(k) profit sharing allows employers to choose whether or not to add additional contributions to employees’ retirement accounts after a successful fiscal year. The key here is that employers get to choose whether or not to contribute in a given year, whereas, depending upon the type of plan, employer matching 401(k) contributions may be required each year.
But why would an employer want to distribute a portion of the company’s yearly profits among employees to share rather than keep it as profit? There are actually many benefits and reasons for doing so.
Benefits of profit sharing for the employer
When businesses implement a profit sharing plan in their organization, they’re showing their employees that they were a critical component to the company’s success and want to reward them for their hard work by adding some extra money into their 401(k). And while this may seem like the benefit is specific to the employees, in reality, the employer enjoys many benefits as well—such as:
Profit sharing plans provide ultimate flexibility for the business owner, allowing the employer to make the plan as simple or complex as they want. Business owners can determine whether contributions will be made in the form of cash or company stock, set eligibility requirements and vesting schedules, and decide how much to contribute to employees—or whether to make a contribution at all.
Once the profit sharing contribution is deposited into the plan, it is divided among the participants according to the allocation method chosen in the plan document. The most common is pro-rata where each participant shares in the profit sharing contribution based on the ratio of their compensation to the total compensation of all participants. Another method is to simply give everyone an allocation based on the same percent of pay, for example, 3 percent of salary. Another popular technique that works in certain situations is to divide the employees into groups and then allocate specific amounts to each group. If this last method is used, the groups must be defined ahead of time in the plan document.
Similar to other retirement savings vehicles, like 401(k) plans, employer contributions to a profit-sharing plan are tax-deductible for the company for the year in which they are made. That being said, you didn’t need to have made a profit sharing contribution by December 31 for the 2018 calendar year just to capitalize on the tax advantages of profit sharing; businesses have until the corporate tax filing deadline (March 15, 2019) to contribute profit sharing funds to the 401(k) plan for 2018. This gives business owners a chance to review yearly profits, determine whether or not to utilize profit sharing, and decrease the company’s taxable income all before filling annual business taxes.
Plus, since earnings in profit sharing plans generally aren’t taxed by Federal or state governments until the funds are withdrawn, business owners are gaining tax advantages on an individual level as well.
Attracting and retaining talented employees
Think a profit sharing plan won’t (or can’t) attract and retain talented employees? Think again—81 percent of workers agree that retirement benefits offered by a prospective employer are a major factor in their final decision when job hunting .
It’s no secret that today’s workers expect help from their employers with preparing for retirement, and adding an extra boost into their 401(k) account at the end of the year goes a long way in showing employees that you not only care about their financial future and livelihood, but you’re also willing to go above and beyond to help them become more retirement ready.
Utilizing a profit sharing plan to help employees save for retirement
As mentioned, utilizing a 401(k) profit sharing plan can help employees reach maximum retirement readiness—in part because, unlike an employer match in a 401(k), employees don’t need to be contributing to their retirement account to earn the profit sharing contribution. Depending on the eligibility requirements you set as the employer, all employees can receive a profit sharing allocation even if they are not making 401(k) contributions. This is especially helpful for low-earners who may not make enough to feel like they can comfortably put away a portion of their paycheck for retirement savings—giving them, essentially, an automatic boost in their 401(k) account.
Plus, despite maximum contribution limits imposed on workers’ 401(k) accounts, profit sharing does not impact the amount employees can save in their 401(k) on their own. Employees can save up to $19,000 in their 401(k) account in 2019 ($25,000 for those aged 50 and over), but profit sharing contributions don’t count towards that limit. Instead, the maximum 401(k) contribution limit for combined employee and employer contributions is $56,000 (or $125,000 for Highly Compensated Employees) in 2019.
How to know if you should offer a profit sharing 401(k)
Clearly, there are benefits to offering a profit sharing 401(k) plan. But knowing whether or not it makes sense for your small business to do so is an entirely different story.
Profit sharing plans are a great option for start-up companies and small businesses that have erratic profitability because contributions are discretionary. Made a ton of revenue and had large profit margins this year? Go ahead and celebrate with employees by offering some shares of company stock. On the flipside, if next year you have a down year and can’t afford to spend any more money at year-end, profit sharing gives you the power to choose not to contribute.
Companies looking to save on corporate taxes at year-end or that want to reward employees for making a positive impact on the business’s overall bottom line may also want to consider profit sharing options. As we mentioned earlier, there are certain tax advantages to offering profit sharing, and employees will undoubtedly appreciate the boost in their 401(k) savings. Plus, it reminds employees that they’re all working toward the same goal and gives them a vested interest in helping the company succeed.
It’s important to note, however, that some employers may not qualify for the most flexible types of profit sharing plans. Plans must pass non-discrimination testing on a yearly basis, designed to level the playing field between contributions for highly compensated employees and rank-and-file employees. To pass annual non-discrimination testing, you’ll want to make sure you have a properly-structured plan in place before announcing the new plan to employees and certainly before making any contributions to the plan.
How to structure profit sharing at year-end
When setting up your profit sharing plan, there are a variety of decisions you’ll have to make. First, and perhaps most importantly, you’ll need to determine the method you’ll use to allocate contributions to each employee. There are a variety of methods for doing this, but it’s important to remember that the method you use cannot favor highly compensated employees over other employees, or your plan will be out of compliance. It’s important to note that the method you chose must be stated in your plan document and generally cannot be changed during the year. To determine which allocation method may be best for your small business, you’ll want to contact a trusted financial advisor or small business retirement plan professional.
Most commonly, profit sharing contributions are a one-time lump sum deposit into the participant’s account—usually at year-end after you’ve had a chance to evaluate business earnings and determine how much (or if at all) you’ll contribute. And to reiterate—this process doesn’t need to be completed by the end of the calendar year. You’ll have until the corporate tax filing date of March 15 to make profit sharing contributions to employees for the previous year.
It’s also important to be aware that you’ll be taking on some hefty responsibilities when you introduce a small business 401(k) profit sharing plan. If you choose to take on plan management and operation by yourself, you’ll be accountable for the essential elements of running the plan, like making timely contributions, following vesting schedules, passing non-discrimination testing, acting as a responsible fiduciary, disclosing plan information to eligible employees, distributing benefits, and filing year-end reporting—to name a few. These responsibilities are often cumbersome to the average employer, so many plan sponsors choose to hire a plan administrator to help operate their plan and stay in compliance. There are some retirement plan providers (Wink, Wink) that take things a step further—helping relieve the plan sponsor of many of these responsibilities and limiting the plan sponsor’s fiduciary liability.
401(k) profit sharing checklist
This is a lot of complex information—there’s no doubt about that. It can be hard to determine whether profit sharing is a good option for your small business without in-depth research and vetting, but the DOL provides a helpful little checklist to help employers determine if they’re ready to offer a plan that will work hand-in-hand with their 401(k).
Before deciding to offer profit sharing, employers should:
Decide whether to hire a financial institute or retirement plan professional to help set up and run the plan
Adopt a written plan document that includes the features you’d like to offer (such as contribution allocations, eligibility requirements, vesting schedules, etc.)
Notify eligible employees and provide them with plan-related information
Determine whether to arrange a trust for the plan assets or solely utilize insurance contracts
Develop a recordkeeping system (or hire a recordkeeper)
Decide how much to contribute to the plan
Determine and understand your fiduciary responsibility as it relates to the plan
Understand the reporting and disclosure requirements of the plan .
We know the retirement industry is not a simple one to navigate for small business owners, but you’re not in it alone. For additional help in establishing and operating a 401(k) profit sharing plan, you may want to speak with a trusted professional familiar with the ins and outs of the retirement industry. To speak with one of PAi’s retirement plan professionals, contact us today: 800.236.7400.
 Profit Sharing Plans for Small Businesses, U.S. Department of Labor, 2018.
 Striking Similarities and Disconcerting Disconnects: Employers, Workers and Retirement Security, Transamerica Center for Retirement Studies, 2018.