Defined Contribution Plans

Profit-Sharing Plans

A profit-sharing plan accepts employer contributions and can be designed to allow for employer discretion regarding the amounts and timing of those. The amount contributed each year to the plan isn’t fixed and an employer may even make no contribution to the plan for a given year.

Although it is called a “profit-sharing plan,” except for contributions by the self-employed, the business doesn’t have to make a profit for the year in order to contribute.

You can be more flexible in making contributions to a profit-sharing plan than to a money purchase pension plan or a defined benefit plan. However, when an employer does make profit-sharing contributions, there must be a set formula that meets non-discrimination rules for determining how the contributions are allocated. Contributed money goes into a separate account for each participant.

Profit Sharing Plan Features

  • Flexible contributions – contributions are strictly discretionary
  • Provides flexibility if cash flow is unpredictable
  • Administrative costs may be higher than under more basic arrangements (SEP or SIMPLE IRA plans)
  • Testing is required to ensure that the plan does not discriminate in favor of highly compensated employees.

Profit-Sharing Plan Contributions

Only employer contributions are made in a Profit-Sharing Plan. If a salary deferral feature, also known as a Cash or Deferral Arrangement (CODA), is added to a profit-sharing plan, it is a “401(k) plan.”

Contribution Limits for Profit-Sharing Plans

Profit-sharing contributions are limited to the lesser of 25% of compensation or $54,000 for 2017 and are subject to cost-of-living adjustments for later years.

Profit Sharing Plan Filing Requirements

Annual filing of a Form 5500-series return/report is required. Participant disclosures are also required. If the plan is a “one-participant plan” and assets are less than $250,000 no filing is required.

Traditional 401(k) Plans

A 401(k) plan is a qualified plan that includes a feature allowing an employee to elect to have the employer contribute a portion of the employee’s wages to an individual account under the plan. This option, governed by Section 401(k) of the Tax Code, is a CODA (Cash or Deferral Arrangement). The underlying plan can be a profit-sharing, stock bonus, or a pre-ERISA money purchase pension. Deferred wages – elective deferrals – are not subject to federal income tax withholding at the time of deferral and  are not reported as taxable income on the employee’s individual income tax return.

401(k) plans are permitted to allow employees to designate some or all of their elective deferrals as “Roth elective deferrals” that are generally subject to taxation under the rules applicable to Roth IRAs. Roth deferrals are included in the employee’s taxable income in the year of the deferral.

Rules relating to traditional 401(k) plans require that contributions made under the plan meet specific nondiscrimination requirements. In order to ensure that the plan satisfies these requirements, the employer must perform annual tests, known as the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, to verify that deferred wages and employer matching contributions do not discriminate in favor of highly compensated employees.

Traditional 401(k) Plan Contribution Limits

Two annual limits apply to contributions:

1. A limit on employee elective deferrals: The limit on employee elective deferrals is $18,000 for 2017. The salary deferral limit applies to aggregate elective deferrals made to all plans in which an individual participates. If permitted by the 401(k) plan, participants who are age 50 or over at the end of the calendar year can make additional elective deferrals of up to $6,000 (for 2017) as catch-up contributions.

2. An overall limit on contributions to all of an individual’s accounts in plans maintained by one employer (and any related employer): The annual additions paid to a participant’s account cannot exceed the lesser of:

  • 100% of the participant’s compensation, or
  • $54,000 ($60,000 including catch-up contributions) for 2017 including the total of all employer contributions, employee elective deferrals and any forfeiture allocations.

The amount of compensation that can be taken into account when determining employer and employee contributions is limited to $270,000 for 2017.

In contrast to the salary deferral limits, other annual additions are not aggregated across plan sponsors – allowing an individual that participates in plans sponsored by other businesses, such as an individual’s Solo 401(k), to exceed the overall plan limits.

Traditional 401(k) Plan Tax Benefits

Tax advantages of sponsoring a 401(k) plan are:

  • Employer contributions are deductible on the employer’s federal income tax return to the extent that the contributions do not exceed the limitations described in Section 404 of the Internal Revenue Code.
  • Employee elective deferrals and investment gains are not currently taxed and enjoy tax deferral until distribution. Employee deferrals that are  Designated Roth Contributions are currently taxable, but all subsequent growth of those funds are tax-free.

An employer’s deduction for contributions to a defined contribution plan (profit-sharing plan or money purchase pension plan) cannot be more than 25% of the compensation paid (or accrued) during the year to eligible employees participating in the plan.

Self-employed individuals making contributions for themselves perform a special computation to calculate their tax deductions. The amount of the deduction can be determined using the worksheet provided in IRS Publication 560. For the self-employed, compensation is defined as net earnings from self-employment, which takes into account both the following items.

  • The deduction for the deductible part of self-employment tax.
  • The owner’s deduction for contributions to the plan.

Use our Solo 401k Contribution Calculator to see what you can contribute to a Solo 401k and SEP-IRA.

Top Heavy Rules for Traditional 401(k) Plans

A plan is top-heavy when, as of the last day of the prior plan year, the total value of the plan accounts of key employees is more than 60% of the total value of the plan assets.

If a 401(k) plan is top-heavy, the employer must contribute up to 3% of compensation for all non-key employees still employed on the last day of the plan year. This contribution is subject to a vesting schedule requiring participants to be vested either (A) 100% after three years or (B) 20% after 2 years, 40% after 3, 60% after 4, 80% after 5 and 100% after 6 years.

Traditional 401(k) Plan Filing Requirements

Annual filing of a Form 5500-series return/report is required. Participant disclosures are also required. If the plan is a “one-participant plan” and assets are less than $250,000 no filing is required.