Last week I had a client ask me whether they should offer a profit-share for their employees. They were curious about the tax benefits and if it made sense for them to make the contribution. I’m going to go over the advice I gave them, and help you learn more about profit-shares and 401k matches for your small business.
What is a Profit-Share?
Think of Profit-Sharing as bonuses you give your employees that also have tax benefits. The owner of the business (i.e., the employer) will take some of the company profits and reward it to both the employees and owners, usually at the end of the year.
Profit-Sharing is provided through employer sponsored retirement plans (such as 401(k)s, SIMPLE IRAs, or Defined Benefit Plans.) Profit-Sharing is very common and is used to attract talented people to come work for your business. They increase worker loyalty and helps cultivates the mindset that your employees have a career where they are working, and not just another job.
Tax Benefits of a Profit-Share
Profit-sharing is deductible to both the business and its employees. The employees don’t have to pay taxes on their profit share when they receive it. They pay tax on the profit-share once they withdraw the money out of their retirement plans, starting over the age of 59 ½. The business also gets a deduction for the profit contribution or 401k match they give to their employees.
Profit-Share Requirements
There are a few rules that you must follow from both the IRS and DOL (Department of Labor):
- You must file an annual IRS Form 5500 with the Department of Labor
- There are limits on how much you can contribute
- You must disclose all the plan participants (employees part of the profit share)
Difference between 401k Matching and a Profit-Share
It’s important to know that 401k Matching is different from Profit-Sharing plans. Even though 401k Matching is a form of profit-sharing, it is based on a specific formula. And the employer may only provide the matching to employees that also contribute to a 401k themselves. Profit-sharing plans are different because they do not require the employees to contribute to any plan first.
This doesn’t mean that you need to set up two different plans. Employers can combine 401ks with Profit-Share plans (referred to as “Combination Plans”) to offer the benefits of both 401ks and profit-shares. However, you must check with your 401k provider that you’ve elected to include the Profit-Share as part of the 401k.
In other words, the plan administrators (people who run the 401k) must know that you are setting up a Combination Plan and not just a 401k Matching plan.
401k Matching Methods
There are multiple methods in which you can offer 401k match. Below I’m going to go over the 3 most popular ones:
- Pro-Rata Method – everyone receives the same rate (the most common)
- Cross Testing Method – different rates for different groups (the best for owners)
- Age-Weighted Plan – Give more to the oldest employees (the best for retaining talent)
Remember, in 401k matching plans, the employee must contribute in order to receive matching from the employer. So for the examples below, we assume that all the participates have contributed to a 401k.
Pro-Rata Method
Also known as “Comp-to-Comp” plans. You give your employees a match based on their salary, up to the amount they have contributed. For example, you have 3 employees that made $30K, $60K, and $90K. You offer them a 3% match. The profit-share would be as follows:
| Employee | Salary | 3% Employer Match |
|---|---|---|
| Adam | $30,000 | $900 – ($30,000 x 3%) |
| Beatty | $60,000 | $1,800 – ($60,000 x 3%) |
| Steve | $90,000 | $2,700 – ($90,000 x 3%) |
| Totals | $180,000 | $5,400 |
The total cost to the employer is $5,400 which is deductible.
Cost-Testing Plans
Also called “New Comparability” plans. You put your workforce into different benefit buckets based on job, age, years of services, etc. You can have 2 or more groups (usually there’s one bucket for the owners, and another bucket for the rest of the employees). You have different contributes rates for each bucket. For example, the owners can be in a 12% match bucket, and the rest of the employees can be in 3% match bucket. Here’s a table to help you visualize it:
| Employee | Salary | % of Match | Employer Match |
|---|---|---|---|
| Owner | $125,000 | 12% | $15,000 – ($125K x 12%) |
| Adam | $30,000 | 3% | $900 – ($30,000 x 3%) |
| Beatty | $60,000 | 3% | $1,800 – ($60,000 x 3%) |
| Steve | $90,000 | 3% | $2,700 – ($90,000 x 3%) |
| Totals | $305,000 | $20,400 |
The total cost to the employer is $20,400 which is deductible as a business expense, but the owner gets to keep $15,000, which goes into their own 401k.
Age-Weighted Plans
Age-Weighted Plans – These plans give the employees that have been around the longest, better rates. For example, when you hire a new employee, you may offer them a 3% match. But after they’ve worked for you for a couple years (vesting period) their match jumps up to 6%. This encourages employees to say around longer.
| Employee | Salary | Years worked | % of Match | Employer Match |
|---|---|---|---|---|
| Adam | $30,000 | < 2 years | 3% | $900 – ($30,000 x 3%) |
| Beatty | $60,000 | < 2 years | 3% | $1,800 – ($60,000 x 3%) |
| Steve | $90,000 | > 2 years | 6% | $5,400 – ($90,000 x 6%) |
| Totals | $180,000 | $8,100 |
What’s a Good 401 Match?
There are all sorts of formulas you can use for 401k matching. Every company can use different ones, so I’m going to share with you the most common ones:
- Partial Match – 50 cents for every $1 you contribution, up to 6% of your salary
- Full Match – $1 dollar for every $1 you contribution, up to 5% of your salary
- Basic Safe Harbor – 100% on first 3% put in, 50% on next 3-5% put in by employees
- Enhanced Safe Harbor – 100% on first 4-6% put in by employee
- Non-Elective Safe Harbor – 3%+ of employee compensation, regardless of employee deferrals
These are the most common, but it is up to the employer which plan they offer.
401k Profit Sharing Limits
401k limits are adjusted for inflation and are set by the IRS every year. The 401k limits for 2022 and 2023 are:
| Type of Retirement Plan | 2023 Contribution Limit | 2022 Contribution Limit |
|---|
| Employee Contribution (under 50) | $22,500 | $20,500 |
| Employee Contribution (over 50) | $30,000 | $27,000 |
| Total Contributions (including match) | $66,000 | $61,000 |
Does the Employer Match Count Toward the 401k Limit?
The employer match (profit-share) does not count toward the yearly employee contribution limit. However, it does count against the total contribution limit.
Should I Offer a Profit-Share to my Employees?
There are many factors you need to consider when deciding to offer a Profit-Share to your employees such as:
- How profitable is the company?
- Is the company on a similar financial trajectory next year?
- What is the total amount of the Profit-Share contribution going to be?
- As the owner, how much of the Profit-Share should I expect?
- As an owner, what tax bracket are you in?
It’s been my experience that if your business is in a 30%+ tax bracket and you can keep 65%-75% of the profit share for the owners, then you should make the profit share contributions to your employees. That’s because, if you don’t make the contribution, you’ll end up giving that money to the IRS anyway (you might as well give it to your employees instead.) Here’s an example that explains what I mean:
Profit-Sharing Example
You own a company that made $1,000,000 of net profit and is in a 30% tax bracket. This means you’re going to owe the IRS $300,000 in tax ($1M x 30%.) You reach out to your TPA (Third Party Administrator, they run the numbers for Profit-Share plans) to find out all the details about how much you can contribute to the plan, how much your employees get, and how much the owners get.
The TPA tells you that you can contribute an extra $100,000 to the Profit-Share. $30,000 of it will go to the employees and $70,000 will go to the owners. Whether you fund the Profit-Share or not, you’re going to be out $100,000. Here’s why:
| Category | No Profit-Share | $100,000 Profit Share |
|---|---|---|
| Net Income (before profit share) | $1,000,000 | $1,000,000 |
| Profit-Share (deduction) | ——0—— | <$100,000> |
| Taxable Net Income | $1,000,000 | $900,000 |
| Tax Rate | 30% | 30% |
| Tax you pay to the IRS | $300,000 | $270,000 |
| Employee Profit-Share | ——0—— | $30,000 |
| Money you’re out of pocket | $300,000 | $300,000 |
In the first scenario where you don’t contribute to the plan, you pay the IRS $300K in tax. If you decide to fund the Profit-Share by $100K, your tax goes down to $270K, but you’re also giving your employees $30,000. In either case you are out $300,000. The only difference is if you rather give the extra $30,000 to your employees or to the IRS.
Common Question
Does it always work out this perfectly? The short answer is no.
The TPA must calculate the amounts you can contribute, you then have to take that information to your CPA to see what tax bracket you’re in, and then decide if it makes sense.
Sometimes the split is 65% owner / 35% employee (more heavily favoring employees.) As a business owner, you need to assess what value your employees have to you and if it’s worth it. I’ve seen many companies that have a 55% owner / 45% employee split, with a 35% tax bracket, still offer the Profit-Sharing.
Conclusion
After going over the numbers with my client and their TPA, they decided in made sense to fund the Profit-Share. Even though the math wasn’t as perfect as in my example, they made the decision that they rather give money to their employees rather than the IRS. Keep in mind, offering Profit-Shares with 401ks are complicated, and that you must consult with both your TPA and tax professional before you know if it makes sense for you to offer this to your employees.