When you’re setting up a 401(k) plan for your company, you might come across the term profit sharing contribution. Despite its name, it's not actually tied to your company's profits—it works a bit differently.
What Is a Profit Sharing Contribution?
A profit sharing contribution is extra money that you, as the employer, can choose to add to your employees' 401(k) accounts. This contribution is discretionary, which means you get to decide:
Whether to contribute each year. There's no annual obligation.
How much to contribute. The amount you choose should align with IRS rules.
How Can You Allocate Profit Sharing Contributions?
When allocating profit sharing contributions among your employees, you have several options:
Group-Based Allocation:
This method offers the most flexibility.
It allows for maximum contributions to owners and minimum contributions to employees.
You can create employee groups and determine the allocation for each group or even individual.
Remember, though, that total contributions must comply with IRS 401(k) rules—you can't exclusively reward company owners.
Pro-Rata Contribution:
Using this method, each employee gets the same percentage of their pay as a contribution to their 401(k) account.
It’s simple and fair, making it a popular choice.
Integrated Formula:
Employees who earn more than a certain amount (usually the Social Security wage base) receive a slightly higher contribution to their 401(k).
This is allowed because employers don't pay Social Security tax on all wages for high earners, unlike for lower-paid employees.
Why Offer Profit Sharing?
Profit sharing contributions are a great way to reward your employees, especially in good years. Since you aren’t required to make these contributions every year, you can skip them in years when your company isn’t doing as well. This flexibility makes profit sharing a valuable feature in a 401(k) plan, especially for small businesses.