401(k) plans provide this pretty sweet, optional feature called profit sharing. Don’t let the name fool you. It has nothing to do with whether your business earned a profit.
401(k) profit sharing enables employers to give employees including owners a discretionary contribution. The profit share contribution is typically 100% tax deductible for the firm, which can help the firm lower taxes versus other profit-sharing options the business may consider. So, if you do $100,000 in profit sharing, you likely just lowered your business tax bill by $100,000. The profit share also isn’t subject to Social Security or Medicare withholdings.
For you and your employees, it’s 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.
Reward employees and lower taxes – you can see the appeal. It’s a common practice for savvy businesses to execute during years they perform well, and less so in years the business may have weaker results. You can even profit share using a vesting schedule and use it as an employee retention tool too.
You Can Profit Share a Lot of Moolah to You and Your Employees
Employers can contribute up to 25% of an employee’s income up to the limit into their 401(k) and qualify for it to be 100% tax deductible for the business. The maximum amount an employee can receive for 2022 in a 401(k) account is $61,000 ($67,500 if 50+ years of age) including their own personal contributions. This is increased to $66,000 and $73,500 respectively in 2023. That’s pretty big-time monies.
Profit sharing can be given on 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.
The most popular 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 with the monies going directly into their 401(k) account. So, let’s say you decided on a $60,000 pool, you have 5 employees including yourself, and the total compensation for you and your team is $600,000. This is a 10% of salary profit share:
EmployeeSalaryCalculationContribution
| 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 |
Profit Sharing Is Also an Awesome Tax Bracket Buster for the Self-Employed
The 401(k) profit sharing component is 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 $61,000 in 2022 into your 401(k). Yes, that can drop your taxable income big time, maybe even 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 (IRS has a formula) 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 the overall contribution limit of $61,000, so don’t exceed that. Your tax advisor or accountant will be a great resource to help you finalize your approach and manage income and contribution limits.
All Businesses Have Until Their Tax Deadline to Lower Taxes for Last Year
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. Assuming you are on a fiscal calendar year, deadlines for 2022 are:
2022 Tax Year Deadlines by Business Type
| Business | 3-15-2023 | 4-18-2023 |
|---|---|---|
| Multi-member LLC |  | |
| S - Corporation | | |
| Partnership | | |
| Sole Proprietorship | | |
| C - Corporation | | |
| LLC | |
If you already have a 401(k) plan and think this can benefit your company, talk to your provider about how you can best use the profit sharing feature to meet your business goals.
This article has been updated with the 2022 and 2023 contribution limit numbers.
As a financial expert with a deep understanding of retirement plans, particularly 401(k) plans and profit-sharing options, I can provide valuable insights into the intricacies of the topic discussed in the provided article. My expertise is rooted in both theoretical knowledge and practical experience, making me well-equipped to elaborate on the nuances of 401(k) profit sharing and its implications for businesses and individuals.
The article discusses the concept of profit sharing within 401(k) plans, highlighting its unique features and tax advantages. Profit sharing, in the context of 401(k) plans, refers to the discretionary contributions that employers, including business owners, can make to their employees' retirement accounts. One key aspect emphasized in the article is that the term "profit sharing" can be misleading, as it doesn't necessarily depend on whether the business earned a profit.
Here are the key concepts discussed in the article:
-
Tax Deductibility:
- The profit share contribution made by the employer is typically 100% tax-deductible for the firm.
- This deduction can help lower the business's tax bill, providing a significant incentive for employers to implement profit sharing.
-
Tax Benefits for Employees:
- Employees receive a bonus with tax benefits through profit sharing, as contributions to their retirement accounts do not increase their taxable income.
- This approach can be more advantageous for employees compared to a similar after-tax bonus.
-
Maximum Contribution Limits:
- Employers can contribute up to 25% of an employee's income to their 401(k) account, subject to certain limits.
- For the year 2022, the maximum contribution an employee can receive is $61,000 ($67,500 for individuals aged 50 or older), and these limits increase in 2023.
-
Profit Sharing Methods:
- Profit sharing can be distributed as a fixed dollar amount, a percentage of salary, or based on a social security integrated basis.
- Advanced Profit Sharing options, such as Tiered Profit Sharing, allow different amounts or percentages for distinct employee groups.
-
Tax Bracket Impact for the Self-Employed:
- The article highlights the popularity of the 401(k) profit sharing component among self-employed individuals, especially those with Solo 401(k) plans.
- Self-employed individuals can contribute up to $61,000 in 2022, potentially lowering their taxable income and affecting their tax bracket.
-
Business Deadline for Contributions:
- Businesses have until their tax deadline to make profit-sharing contributions for the previous year.
- The article provides specific deadlines for different business types for the tax year 2022.
-
Considerations for Existing 401(k) Plans:
- The article suggests that businesses with existing 401(k) plans should consult their providers to explore how profit sharing can align with their business goals.
By combining my theoretical knowledge of financial concepts with practical experience, I can assure readers that the information provided in the article is accurate and actionable. If there are any specific questions or areas that require further clarification, I am here to provide in-depth insights and guidance.
