Quick Summary
Profit sharing contributions are discretionary employer contributions that do not depend on the company actually having profits. Allocation methods range from simple pro rata formulas to new comparability designs that test contributions as projected retirement benefits. New comparability can direct a larger share to owners and key employees, provided rank-and-file employees receive a minimum gateway contribution and the plan passes nondiscrimination testing. These designs require a third-party administrator who runs illustrations each year.
A 401(k) match is the employer contribution most people know. A profit sharing contribution is the more flexible one. It lets a business decide each year how much to contribute and, within the rules, how to divide it among employees.
For owners of small businesses and professional practices, a well-designed profit sharing feature can significantly increase their own tax-deductible retirement savings while still providing meaningful contributions to employees.
What a profit sharing contribution is
Despite the name, a profit sharing contribution does not require the company to have profits. It is a discretionary employer contribution, typically decided after the year ends based on how the business performed and what it can afford.
A few key rules apply:
- Deduction limit. Total employer contributions to a defined contribution plan are generally deductible up to 25% of eligible payroll.
- Timing. To be deducted for a given tax year, contributions generally must be deposited by the company's tax return due date, including extensions.
- Individual limit. Each participant's total contributions from all sources, including their own deferrals and employer contributions, are subject to an annual additions limit that the IRS adjusts each year. Catch-up contributions for participants age 50 and older are allowed on top of that limit.
Allocation methods
The plan document sets how the contribution is divided. Common approaches include:
Pro rata. Every eligible employee receives the same percentage of pay. It is simple and easy to explain.
Integrated, or permitted disparity. Employees receive a higher percentage on compensation above a set level, typically tied to the Social Security wage base. This recognizes that Social Security replaces a smaller share of income for higher earners.
Age-weighted. Older employees receive larger contributions, based on how many years they have until retirement.
New comparability, or cross-tested. Employees are placed in groups, often with each employee in their own group, and each group can receive a different contribution rate. The plan then tests the result for fairness by converting contributions into projected retirement benefits.
How new comparability works
The logic comes down to time. A contribution made for a 30-year-old has decades to grow before retirement. A contribution made for a 58-year-old has far less time. When contributions are converted into projected benefits at retirement age, a smaller contribution for a younger employee can produce a benefit comparable to a larger contribution for an older one.
When owners are older than most of their staff, new comparability can direct a larger share of the total contribution to owners while still passing nondiscrimination testing.
The gateway requirement
New comparability designs come with a floor for rank-and-file employees. In general, each non-highly compensated employee must receive at least the lesser of:
- 5% of compensation, or
- One-third of the highest contribution rate given to any highly compensated employee
A safe harbor nonelective contribution of 3% counts toward this gateway.
Pairing with safe harbor
A common design combines three elements:
- A 401(k) feature, so everyone can defer
- A 3% safe harbor nonelective contribution, so the plan avoids ADP testing and the owner can defer the maximum
- A new comparability profit sharing contribution, which tops staff up to the gateway and directs additional contributions to owners
In this structure, owners can often reach the annual additions limit while employees receive a meaningful contribution.
Who it fits
New comparability tends to fit businesses where:
- Owners or key employees are older than the average employee
- Cash flow is steady enough to fund contributions most years
- Owners want to maximize tax-deductible retirement savings
- The business is a professional practice, such as a medical, dental, legal, or accounting firm
It is less effective when owners are younger than most of their staff, or when cash flow is unpredictable.
The annual process
Each year, the third-party administrator collects census data, runs illustrations showing several contribution scenarios, and helps the owners choose an amount. After the contribution is deposited, the TPA confirms that the plan passes testing. That flexibility to decide each year is one of the main advantages of profit sharing.
Other considerations
- Profit sharing contributions can be subject to a vesting schedule, unlike traditional safe harbor contributions.
- Top-heavy minimum contribution rules may apply.
- Coverage testing still applies.
- Employees should receive clear communication about how contributions are allocated.
Want to see whether a profit sharing design could work for your business? Brian Williams, CPFA®, of Northshire Consulting LLC | Registered Investment Advisory Firm meets with business owners to review plan design. Call 203-401-6062, email bwilliams@northshireconsulting.com, or visit northshireconsulting.com to schedule a plan review.
Frequently asked questions
Does a company need to be profitable to make a profit sharing contribution?
No. The contribution is discretionary and does not depend on profits.
Can the contribution amount change from year to year?
Yes. Within the terms of the plan document, the employer can decide each year how much to contribute, including nothing in some years.
Does the IRS allow new comparability designs?
Yes. IRS regulations permit cross-testing, subject to the gateway requirement and nondiscrimination rules.
This material is for educational purposes only and is not individualized investment, tax, or legal advice. Advisory services are offered through Northshire Consulting LLC | Registered Investment Advisory Firm.