Profit-Sharing Plans & Contributions

A profit-sharing feature allows employers to contribute to employee retirement accounts in a flexible way without the guaranteed commitment. Instead, plan sponsors can control contributions based on how well their business did during the year.

Profit-Sharing Plan Allocation Formulas

A 401(k) plan with a profit-sharing feature works like any other 401(k) plan, but the plan sponsor sets aside a portion of its pre-tax profits to contribute as a profit-sharing contribution, and the allocation method determines how the total amount is split amongst the employee's retirement accounts. There are three primary ways to allocate the profit-sharing contribution to employees:

  • Pro-rata allocation: This is the most common & simplest option. The total contribution is split up among eligible employees in proportion to the compensation they receive. In simpler terms, the employees receive contributions as a percentage of their compensation.
  • Integrated allocation: This option is slightly more complex and "integrates" with Social Security benefits. Since Social Security is only paid on compensation up to a certain level (the Taxable Wage Base “TWB”), the IRS allows employees that make over the TWB to "double dip" on the compensation that is over that amount. The result is all employees with compensation under the TWB receive an even percentage of compensation, and those that make over the TWB receive a larger allocation of the contribution.
  • New comparability plans: Sometimes called “cross-tested plans,” this option is the most complex method. It is well-suited for employers with older owners and a younger employee base. Owners can receive the maximum possible contribution while using different contribution rates for non-owner employees. The "cross-testing" refers to the additional compliance testing required for this allocation method. The contribution amount per employee is converted to an equivalent benefit at retirement age, similar to an annuity. Generally, younger employees will have a higher equivalent benefit than older employees because they have more time to accrue investment earnings; conversely, older employees will receive a higher contribution because they have less time before retirement to accrue earnings. The plan is then tested based on the equivalent benefit at retirement age.

Timing of Profit-Sharing Deposits and Other Important Rules

Profit-sharing contributions should be made at the end of the plan year, not on a pay period or other basis. New comparability and other allocation formulas can be complex. Because they utilize salary and other participant data, they cannot be calculated precisely until the end of the plan year. Additionally, many plans have a “last-day rule,” which requires participants to be employed on December 31 to receive a benefit. By making a contribution too early in the year, you may pay a benefit to an employee who terminates employment before year-end. The issue will then need to be corrected by retrieving the payment from the participant, which may be impossible, and disclosing it on Form 5500, which could prompt regulatory scrutiny. Vestwell may charge an additional fee for this service. Even without a last-day rule, profit-sharing contributions undergo compliance tests at year-end. If those results differ from what has already been deposited, payments made to existing or former employees may need to be retrieved. Employer contributions to profit-sharing plans for 2023 do not need to be funded until April 15, 2024, or later if the plan sponsor filed an extension for its corporate tax return.

Additional Notes on Plans with New Comparability Formulas

New comparability plans are popular options, but their effectiveness depends on your workforce demographics, and any changes from year to year can impact whether the plan satisfies annual compliance tests. These plans can also be somewhat more expensive for the plan sponsor as compared to other allocation formulas. Please keep in mind that non-highly Compensated Employees (NHCEs) are generally required to receive a minimum “gateway” contribution that is equal to the lesser of 5% of compensation or one-third of the highest percentage allocated to any HCE. That contribution is then projected to benefit the participant at retirement age and tested to confirm that the HCEs do not receive a disproportionately higher benefit as compared to NHCEs. If the test fails, you can increase contributions for the NHCEs, reduce contributions for HCEs, or a combination.

Amending a Plan to Change Allocation Methods

The profit-sharing allocation method to be used must be specified in the plan document. However, allocation methods may be added or changed with a simple plan amendment. The general deadline for making such a change is the end of the year for which the contribution will be made; however, some additional timing restrictions may impose an earlier deadline. Please also note that, in some instances, the change may not be legally permitted to be effective until the first day of the following plan year.

To check which allocation method your plan has, please see Section D of your Adoption Agreement, located in the Plan Documents section of the sponsor portal. 

How to Request a Profit-Sharing Calculation

Profit-sharing contributions are a great benefit for an employer to offer, but since there are many complexities, it is best to let Vestwell calculate the allocation amount for you. The annual year-end questionnaire will ask you if you would like to make a profit-sharing contribution, so please tell us how much you would like to contribute. You will be able to choose a total dollar amount, a percentage of compensation, or max out all owners. Our annual testing team will review your response, compare it to your allocation method in the Adoption Agreement, and let you know if we need any clarification. We will then present you with a profit-sharing contribution report to review, at which point you will determine whether you want to proceed with the contribution or’s up to you! Please note that the profit-sharing contribution report cannot be presented until all items on the annual testing checklist have been received in good order.