Are Profit Sharing Contributions Right for Your 401(k) Plan?

Profit sharing contributions are the most flexible type of employer contribution a company can make to their 401(k) plan.  These contributions are not only discretionary, but they can be made to any eligible plan participant – even if the participant fails to make 401(k) deferrals themselves.  They can also be allocated using dramatically different formulas – allowing employers to meet a broad range of 401(k) plan goals with them. 

Yet, despite their flexibility, profit sharing contributions are not a good choice for every 401(k) plan.  Matching contributions can be more effective in meeting certain 401(k) plan goals.  Further, not all employers will qualify for the most flexible types of profit sharing due to IRS nondiscrimination test limitations.  If you’re a 401(k) plan sponsor, you want to understand your company’s profit sharing contribution options.  To meet certain 401(k) goals, they can be tough to beat.

Profit sharing contribution basics

401(k) profit sharing contributions are a type of “nonelective” employer contribution.  That means employees do not need to make 401(k) deferrals themselves to receive them.  In contrast to safe harbor non-elective contributions, profit sharing contributions are discretionary – which means you don’t have to make them every year. 

Profit sharing contributions can also be made subject to a vesting schedule – up to 3-year cliff or 6-year graded.  This can be handy if you have short-tenured employees because they’ll be required to forfeit some or all of their profit sharing account upon a separation from service.

When to choose profit sharing contributions

Because profit sharing contributions are flexible, they can be a great choice if your company is a start-up, has erratic profitability, or acquires other companies frequently.  If your company is more stable, these contributions can help you meet several 401(k) plan goals, including:

• Increasing the contributions made to 401(k) participant accounts up to the legal limit ($57,000 for 2020, not including 401(k) catch-up deferrals).
• Giving low-earners a base retirement benefit.
• Attracting top employee talent with a generous retirement benefit.

However, not all 401(k) plan goals are best served by profit sharing contributions.  Employer matching contributions are generally the superior choice if a primary 401(k) plan goal is incentivizing your employees to save for retirement themselves.