Planning for retirement is a major financial goal, and businesses are always looking for ways to help their employees build a secure future. One smart option is a profit-sharing 401(k) plan.

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Unlike a traditional 401(k), a profit-sharing 401(k) allows employers to make discretionary contributions based on company performance. This gives businesses more flexibility while helping employees grow their retirement savings without requiring them to contribute.

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It's a win-win: companies can use profit-sharing 401(k) plans to attract and retain top talent, and employees get an extra boost toward their retirement.

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Keep reading to see how a profit-sharing 401(k) works and how to set up one for your business.

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What Is a Profit-Sharing 401(k)?

A profit-sharing 401(k) is a type of retirement plan that combines features of a traditional 401(k) with profit-sharing contributions from an employer. It allows employees to contribute a portion of their salary to their 401(k) account, while the employer can make additional contributions based on company profits.

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However, employer contributions are discretionary, meaning they can vary each year based on company performance.

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Features and Structure of a Profit-Sharing 401(k)

Employer-Only Contributions

Employees do not contribute; the employer determines how much to allocate each year, based on business profits or a fixed percentage.

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Flexible Contribution Structure

Companies can contribute up to 25% of eligible payroll per year, subject to an IRS limit of $69,000 per employee in 2024 ($76,500 for those 50+ with catch-up contributions).

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Vesting Schedule Options

Employers can set vesting schedules, meaning employees may need to stay with the company for a certain period to gain full ownership of employer contributions.

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Profitability Not Required

While called “profit-sharing,” companies do not need to be profitable to contribute (contributions can be discretionary).

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IRS Compliance and Testing

The plan must pass nondiscrimination tests to ensure contributions benefit all employees fairly, not just highly compensated individuals.

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Who Is Eligible to Participate?

Eligibility for a profit-sharing 401(k) plan depends on the employer’s plan structure. However, the IRS sets general guidelines:

• Employers can set minimum service requirements, such as one year of employment.
• Employees must work at least 1,000 hours in 12 months to qualify.
• Some businesses allow part-time employees (working at least 500 hours annually for three consecutive years) to participate.
• Self-employed individuals and business owners can also set up solo profit-sharing 401(k) plans to maximize tax-deferred savings.

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How Does a Profit-Sharing 401(k) Work?

A profit-sharing 401(k) is employer-funded. The amount the employer contributes varies each year. This makes it an attractive option for businesses that want to reward employees while maintaining financial flexibility.

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Here’s an in-depth look at how profit-sharing 401(k) works:

Employer Contributions and How They Are Calculated

Employers decide annually how much to contribute to a profit-sharing 401(k) based on the company’s financial performance.

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However, contributions are not directly tied to actual profits; a business can contribute even in years when it does not generate a profit. Contributions are usually calculated using any of these methods:

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Pro-Rata (Flat Percentage) Method

The employer contributes the same percentage of each eligible employee’s salary. For example, if the employer decides on a 5% contribution rate, an employee earning $60,000 would receive $3,000 in their profit-sharing 401(k).

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Integrated (Permitted Disparity) Method

Contributions are weighted in favor of employees earning above the Social Security wage base. This method allows higher-paid employees to receive a slightly larger percentage to account for Social Security tax disparities.

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Age-Weighted or New Comparability Method

Contributions are allocated based on age and compensation. This benefits older employees who are closer to retirement. The age-weighted or new comparability method is common in businesses with a mix of younger and older employees.

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Vesting Schedules

Vesting refers to the percentage of employer contributions an employee owns when they leave the company. Employers set their vesting schedules, which must comply with IRS rules.

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Immediate Vesting

Here, employees own 100% of employer contributions as soon as they are deposited. This structure is ideal for companies looking to attract and retain top talent.

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Graded Vesting

Employees gradually earn ownership of employer contributions over time. The IRS allows a maximum six-year vesting schedule under the following structure:

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Some employers use a cliff vesting schedule, where employees become fully vested after three years of service. If an employee leaves before the vesting period is complete, they forfeit the unvested portion of employer contributions.

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Benefits of a Profit-Sharing 401(k)

Companies can use profit-sharing 401(k) to attract and retain top talent while enjoying tax benefits. At the same time, it helps employees build their retirement savings without the burden of personal contributions.

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For Employers

Attracting and Retaining Top Talent

Employees are more likely to stay with organizations that invest in their financial future. A 2023 SHRM report found that 82% of employees consider retirement benefits an important factor in choosing an employer.

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Companies with strong retirement plans experience lower turnover rates, thereby reducing recruitment and training costs.

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Tax Advantages for Businesses

Employers can benefit from substantial tax savings when contributing to a profit-sharing 401(k). This is because:

• Employer contributions are tax-deductible up to the IRS limit, reducing taxable income.
• Small businesses may qualify for the SECURE Act tax credit, which provides up to $5,000 per year for three years to cover retirement plan startup costs.
• Contributions are exempt from payroll taxes, leading to additional savings.

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Flexibility in Contributions

Profit-sharing 401(k) helps employers decide how much to contribute based on the company’s financial performance. Businesses can adjust contribution amounts based on profitability. Employers can also implement vesting schedules, thereby encouraging long-term employee retention.

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For Employees

Increased Retirement Savings Potential

A profit-sharing 401(k) helps employees build substantial retirement savings faster than traditional plans. In 2024, the total employer and employee contribution limit is $69,000 (or $76,500 for employees aged 50+ with catch-up contributions); much higher than standard 401(k) limits.

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No Personal Contribution Required to Benefit

Unlike a standard 401(k), where employees must contribute to receive an employer match, a profit-sharing 401(k) provides benefits without mandatory employee contributions. Employees still receive employer contributions, even if they don’t contribute themselves.

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This is beneficial for low-income workers or those with financial constraints who may struggle to contribute to a traditional 401(k).

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Tax-Deferred Growth on Employer Contributions

A profit-sharing 401(k) allows employees to benefit from tax-deferred investment growth, meaning their retirement funds grow faster over time.

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Employer contributions are not immediately taxed; this allows funds to compound tax-free until withdrawal. Also, employees only pay taxes when they withdraw funds during retirement, usually at a lower tax rate.

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This tax advantage helps employees maximize their retirement savings while reducing immediate tax liability.

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Profit-Sharing 401(k) vs. Other 401(k) Plans

Businesses and employees have several options when planning for retirement, including profit-sharing 401(k) plans, traditional 401(k) plans, and SEP IRAs. It’s important to understand the differences between these plans to choose the best fit.

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Profit-Sharing 401(k) vs. Traditional 401(k) Plans

The table below highlights the main differences between profit-sharing 401(k) and traditional 401(k) plans:

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Profit-Sharing 401(k) vs. SEP IRAs

A Simplified Employee Pension (SEP) IRA is another employer-sponsored retirement plan, but it differs from a profit-sharing 401(k) in structure, contribution flexibility, and administrative complexity.

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Which Plan Is Best for Different Business Types?

The right retirement plan depends on business size, financial stability, and employee needs:

• Small Businesses and Sole Proprietors: A SEP IRA is ideal due to its low administrative burden and flexible contributions.
• Growing Businesses with Employees: A traditional 401(k) encourages employee contributions while allowing employer matching.
• Established Businesses with Variable Profits: A profit-sharing 401(k) is best for rewarding employees based on company performance without committing to fixed contributions.

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How to Set Up a Profit-Sharing 401(k) Plan

Setting up a profit-sharing 401(k) plan requires compliance with IRS regulations and choosing the right financial provider. Below are the steps that can guide you in setting up a profit-sharing 401(k) plan:

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Determine the Plan’s Goals and Structure

Before setting up a profit-sharing 401(k), employers should define their objectives. Will contributions be discretionary or follow a set formula? What percentage of profits will be allocated?

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Employers must also decide on eligibility criteria, such as whether all employees qualify or only those who meet specific tenure requirements.

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Create a Written Plan Document

The IRS requires employers to create a written plan document that outlines:

• How contributions will be made
• Vesting schedules (e.g., immediate or graded vesting)
• Distribution rules
• Compliance with Employee Retirement Income Security Act (ERISA) regulations

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This document ensures transparency and helps employers remain compliant with federal laws. Many businesses work with third-party administrators (TPAs) to draft this document.

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Choose a Plan Administrator and Financial Provider

Employers must select a recordkeeper, third-party administrator (TPA), and financial provider to manage the plan’s investments, compliance, and reporting requirements. This step ensures smooth operations and helps avoid regulatory issues.

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Submit the Plan to the IRS and Department of Labor (DOL)

The plan must be filed with the IRS, using Form 5500, to report plan details, participant counts, and financial status. Failure to file this form may result in IRS penalties.

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Inform and Enroll Employees

Once approved, employers must communicate the details of the plan to employees. This includes providing Summary Plan Descriptions (SPDs), enrollment materials, and resources explaining how contributions work.

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Employees should understand the vesting schedule, eligibility requirements, and potential tax benefits.

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Ongoing Plan Administration and Compliance

After setup, employers must conduct annual compliance testing (e.g., nondiscrimination tests) to ensure contributions do not disproportionately favor highly compensated employees (HCEs).

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Employers must also manage ongoing contributions, track participant accounts, and comply with reporting requirements.

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How to Choose a Financial Provider and Plan Administrator

The right financial provider and plan administrator can help you set up a successful profit-sharing 401(k). The ideal provider should offer:

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Low Fees and Transparent Pricing

Providers charge administrative fees, investment management fees, and transaction fees. Look for low-cost providers such as Vanguard, Fidelity, or Charles Schwab, which are known for offering competitive pricing.

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Robust Investment Options

The best providers offer a mix of mutual funds, index funds, and target-date funds to accommodate different risk levels. Some providers offer self-directed brokerage options, allowing employees greater control over investments.

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Ease of Administration and Compliance Support

Look for providers that assist with IRS compliance, including nondiscrimination testing and annual filing of Form 5500. Digital platforms like Betterment for Business and Empower Retirement offer automated administration tools.

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Strong Customer Support

A dedicated support team is important to handle compliance issues, participant questions, and investment guidance.

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Integration with Payroll and HR Software

Many businesses prefer providers that integrate with payroll systems like ADP, QuickBooks, or Gusto to streamline contributions and reporting.

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Legal and IRS Compliance Considerations

The IRS and Department of Labor impose strict regulations on profit-sharing 401(k) plans to ensure fairness and prevent misuse. Important compliance requirements include:

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Contribution Limits and Deductibility

For 2024, total employer and employee contributions cannot exceed $69,000 ($76,500 for employees aged 50 and older). Employers can deduct contributions up to 25% of total compensation paid to eligible employees.

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Nondiscrimination Testing

Employers must conduct annual Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests to ensure that contributions do not favor highly compensated employees (HCEs). If a plan fails these tests, employers must refund excess contributions or make additional contributions to non-HCEs.

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Required Plan Documents and Filings

Employers must maintain:

• Summary Plan Description (SPD) given to employees outlining the plan’s terms.
• Form 5500; an annual report filed with the IRS and DOL.
• IRS Form 1099-R for reporting distributions to employees.

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Fiduciary Responsibilities

Under ERISA Section 404(c), employers have a fiduciary duty to act in employees’ best interests when managing the plan. Failure to follow fiduciary standards can result in lawsuits or Department of Labor penalties.

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Vesting Rules and Distribution Restrictions

Employers can use cliff vesting (100% after a certain period) or graded vesting (gradual ownership over time). Distributions before age 59½ may result in a 10% IRS penalty unless they qualify for hardship withdrawals or early retirement exceptions.

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Wrapping Up

When you offer profit-sharing 401(k), you’re not only helping employees save for the future but also demonstrating your commitment to their well-being.

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However, setting up and managing a profit-sharing 401(k) comes with its share of complexities. From ensuring compliance with IRS regulations to handling contributions, vesting schedules, and financial reporting, the administrative workload can quickly become overwhelming.

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Chore simplifies HR, compliance, finance, and equity management so you can focus on growing your business and supporting your employees.

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With Chore helping you streamline oerations, you can confidently offer benefits like a profit-sharing 401(k) handling the complexities yourself. Learn more.

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FAQs

What is the difference between profit-sharing and solo 401k?

A profit-sharing 401(k) is designed for businesses with employees, where employers make discretionary contributions to employees' retirement accounts. It requires IRS compliance and nondiscrimination testing.

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A solo 401(k) is for self-employed individuals with no employees (except a spouse). It allows employee and employer contributions, offering higher savings potential with fewer administrative requirements.

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The profit-sharing 401(k) is ideal for businesses rewarding employees, while the solo 401(k) is best for self-employed individuals looking for flexible, high-limit retirement savings.

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Can you withdraw money from a profit-sharing plan?

Yes, you can withdraw money from a profit-sharing plan, but rules and penalties apply.

• Penalty-Free Withdrawals: Allowed at age 59½ or upon retirement (taxes may still apply).
• Early Withdrawals: Before 59½, you face a 10% penalty + income tax, unless for hardship exceptions.
• Loans: Some plans allow borrowing up to 50% of vested funds (max $50,000) with repayment in 5 years.
• Required Minimum Distributions (RMDs): Mandatory withdrawals start at age 73.

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Who is eligible for a profit-sharing 401(k)?

Eligibility depends on the employer’s plan rules, but most full-time employees who meet service requirements (e.g., working for at least a year) qualify. Some businesses may also extend eligibility to part-time employees.

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How do employer contributions work in a profit-sharing 401(k)?

Employer contributions in a profit-sharing 401(k) are discretionary; businesses decide annually whether to contribute and how much. Contributions are usually based on a percentage of employees' salaries and must comply with IRS limits (up to $69,000 in 2024, with employer contributions capped at 25% of total payroll).

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Employers can use different allocation methods, such as equal percentage distribution or favoring certain employee groups. Contributions may follow a vesting schedule (immediate, graded, or cliff), thereby affecting how much employees retain if they leave.

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