1099 or Business Owners Understanding the Impacts of Profit Sharing
Profit sharing contributions to a 401(k) plan can be an excellent way for business owners, including those who are self-employed or have a 1099 income, to both motivate employees (if applicable) and save for their own retirement. When it comes to 1099, as you are a single employee, if you have the cash flow to save above the normal $23,500 contribution limits, it can make a lot of sense to consider.
Here’s when it may make sense for business owners to consider doing profit sharing:
1. You Want to Reward Employees (If Applicable)
If you have employees, profit sharing can be a good way to incentivize and reward them. It’s a way to contribute to their retirement savings based on the company’s profitability, which can improve morale and loyalty. It’s also a way to attract and retain talent.
2. You’re Looking for Tax Benefits
Profit-sharing contributions are tax-deductible for the business, which can help lower taxable income. If your business is doing well and you want to reduce its tax burden, profit-sharing contributions can be a smart strategy.
3. You Want to Save More for Your Own Retirement
As a business owner, you can make profit-sharing contributions to your own 401(k) plan. For 2025, the total contribution limit for a 401(k) (including employee deferrals and employer contributions) is $66,000, or $73,500 if you're age 50 or older (including catch-up contributions). Profit-sharing allows you to make additional contributions beyond your own salary deferrals, increasing your retirement savings potential.
4. You Have Variable Income
For self-employed individuals or business owners with fluctuating income, profit-sharing can be beneficial because contributions are based on a percentage of profits. If your income is high in a given year, you can increase your contribution; if it's lower, the contributions can be adjusted accordingly. This flexibility makes profit sharing a good option if your earnings vary year to year.
5. You Want Flexibility in Contributions
Profit sharing offers flexibility in how much you contribute each year. You don’t have to contribute every year, and the amount you contribute can change depending on the company's profitability. This can be especially helpful in years when cash flow is tight.
6. You’ve Maxed Out Employee Contributions
If you’re already contributing the maximum allowable amount to your 401(k) as an employee ($23,000 for 2025, or $30,500 if you’re 50+), profit sharing can be used to boost your retirement savings further.
7. You're Considering a Safe Harbor 401(k)
If you want to avoid the IRS non-discrimination testing (which ensures that highly compensated employees aren’t benefiting disproportionately from 401(k) contributions), you could set up a Safe Harbor 401(k). A Safe Harbor plan requires certain employer contributions, like profit sharing, and provides a pass on these tests, which simplifies the process.
Key Considerations:
Profit-sharing Contributions Are Not Guaranteed: Profit-sharing contributions are typically discretionary, meaning you are not required to contribute every year.
Employee Eligibility: If you have employees, they might need to meet specific eligibility requirements to participate in profit-sharing (e.g., age, tenure).
Contribution Limits: Be mindful of contribution limits for total employer and employee contributions to the 401(k). In 2025, the limit is $66,000 or $73,500 for those 50+ (including both employee deferrals and employer contributions).
Vesting Schedules: If you have employees, you can implement a vesting schedule for the profit-sharing contributions. This means employees may need to work for the company for a certain number of years before they fully own the contributions.
In short, a 1099 earner or business owner should consider profit sharing in their 401(k) plan if they want to enhance retirement savings, reward employees, and take advantage of tax benefits—especially if the business is profitable and has the financial flexibility to contribute.
Calculating Profit Sharing
Now that you get a sense of when to consider profit sharing, which allows you to increase your contributions to the 401(k) to take advantage of pre-tax contributions, you need to understand, their are different calculations. If you have employees, how you calculate this can make a huge different in how much you need to provide to employees versus what you can put aside for yourself. Generally, I strive to make sure that the business owners personal tax savings is more than the cost of contributing to your employees. Coming out with more retirement savings, less taxes, and happier employees.
Here are the most common approaches for calculating profit-sharing contributions:
1. Pro-Rata (Uniform Percentage) Method
This is the most straightforward and common way of calculating profit sharing. Under this method, the employer contributes the same percentage of each eligible employee’s compensation (including the business owner, if applicable).
Example:
If you decide to contribute 5% of compensation as a profit-sharing contribution:
Employee A earns $50,000: Contribution = 5% of $50,000 = $2,500
Employee B earns $100,000: Contribution = 5% of $100,000 = $5,000
Business Owner earns $150,000: Contribution = 5% of $150,000 = $7,500
The employer contributes the same percentage across all employees, including the owner. The advantage of this method is that it’s easy to calculate and ensures equity among employees.
2. New Comparability or "Cross-Tested" Method
This method allows the employer to allocate a larger share of the profit-sharing contribution to highly compensated employees (HCEs) and owners, while still meeting the requirements of the 401(k) non-discrimination rules. The key here is that the employer can "group" employees into different categories (e.g., HCEs vs. non-HCEs) and make different profit-sharing contributions to each group.
This method is often used when the goal is to maximize contributions for the business owner or high-earning employees.
Example:
The employer could decide to allocate 7% of salary for HCEs (like the business owner) and 3% for non-HCEs.
Owner earns $200,000: Contribution = 7% of $200,000 = $14,000
Employee A earns $40,000: Contribution = 3% of $40,000 = $1,200
Employee B earns $60,000: Contribution = 3% of $60,000 = $1,800
However, to use this method, the employer must meet certain nondiscrimination tests, ensuring that contributions do not disproportionately benefit the higher-paid employees.
3. Integrated Profit Sharing (Social Security Integration)
This method allows for higher profit-sharing contributions to be made for employees whose compensation exceeds the Social Security wage base limit (the amount of income subject to Social Security tax). This method “integrates” the 401(k) plan with the Social Security system, providing larger contributions to higher earners.
Example:
If an employee earns above the Social Security wage base (which is $160,200 for 2025), the employer may decide to contribute a higher percentage of salary for income above that threshold (such as 10%) and a lower percentage (like 5%) on income below it.
For example (using hypothetical numbers):
Employee earns $200,000: The employer could contribute 5% of the first $160,200 (Social Security wage base) and 10% of the remaining $39,800.
5% of $160,200 = $8,010
10% of $39,800 = $3,980
Total profit sharing = $8,010 + $3,980 = $12,990
This method can increase retirement savings for employees with higher wages but requires careful planning and understanding of the Social Security limits.
4. Discretionary Method
Under this method, the employer determines the profit-sharing percentage at the end of the year based on company profitability. There is no fixed percentage or formula. The business can decide how much to contribute to each employee's 401(k) plan at the end of the year, often based on the company’s financial performance.
Example:
At the end of the year, the company might decide that it can afford to contribute 10% of each eligible employee’s compensation as a profit-sharing contribution.
Employee A earns $50,000: Contribution = 10% of $50,000 = $5,000
Employee B earns $75,000: Contribution = 10% of $75,000 = $7,500
The disadvantage of this method is that employees don’t know the contribution percentage until the end of the year, making it less predictable.
5. Age-Weighted Profit Sharing
This method allows employers to make larger profit-sharing contributions to older employees (who have fewer years to save for retirement). Contributions are weighted based on an employee's age or years to retirement, allowing employees who are closer to retirement to receive a higher percentage of the total contribution.
Example:
An employer could decide to allocate profit-sharing contributions based on age or retirement proximity, giving employees aged 50+ a larger portion of the contribution pool.
Key Considerations:
Administration firm: For the more basic testing method, like pro-rate, you often can do this without significant assistant. Their are several 401(k) firms set up for lower cost that provide this. However, it might not be the best calculation. Often these firms charge a higher service model to do the additional calculations.
Discrimination Testing: To ensure that profit-sharing contributions are fair and meet IRS requirements, employers must sometimes perform non-discrimination testing (especially with methods like New Comparability or Integrated Profit Sharing). Often employer also do a safe harbor matches for their employees to avoid most forms of discrimination testing.
Each method offers different benefits depending on the structure and goals of your business. If you have employees, you need to have a team of experts slowly walk you through the pros and cons. Most importantly understanding your business’s cash flow and goals. Then determine which profit-sharing method best aligns with your business’s needs and your retirement goals.
Author:
James Hargrave, MBA, CFPⓇ, CLUⓇ