401(k) Profit-Sharing Plans

A 401(k) plan is a type of profit-sharing plan that includes an elective salary deferral provision.

How does a 401(k) Profit-Sharing Plan Work?

The employer typically may make a matching contribution tied to the elective salary deferral, as well as a profit-sharing contribution allocated to all eligible participants. Plan participants usually have the ability to select their own asset allocations from the plan’s various investment alternatives.

What is a Roth 401(k) Plan?

A Roth 401(k) plan is a relatively new feature of a 401(k) plan that permits participants to make after-tax salary deferrals into a 401(k) plan. When an employer elects to offer the Roth 401(k) provision, participants may choose between pretax and after-tax salary deferrals.

Employee eligibility requirements for 401(k) plans are typically one year of service and attainment of age 21.

Roth 401(k) Plan Contributions

The three common 401(k) contribution types are:

  • Elective salary deferral – The indexed amount employees can defer is subject to cost-of-living adjustments and may change each year.
  • Employer matching – Employers can make a discretionary contribution based on a percentage of an employee’s elective salary deferrals.
  • Profit-sharing – Contributions can be allocated in any method available to regular profit-sharing plans.

An employer’s maximum deduction is limited to 25% of the annual compensation paid to eligible employees. In addition, employers must meet several nondiscrimination tests, which may further limit the amounts highly paid employees may defer.

Employees age 50 and older may make a catch-up contribution, which does not count against their individual maximum annual additions limit of the lesser of 100% of compensation or $66,000 for 2023.

Advantages of a Roth 401(k) Plan

  • A 401(k) plan allows both employers and employees to contribute toward retirement while reducing the current tax burdens of both.
  • Because employees are active participants, 401(k) plans typically play a big role in employees’ perception of the benefits provided by their employers.

What is a 401(k) Safe Harbor Plan?

Safe Harbor 401(k) plans are not subject to nondiscrimination tests and, therefore, all employees have the opportunity to maximize deferrals. Employee eligibility requirements are the same as those for 401(k) profit-sharing plans.

401(k) Safe Harbor Plan Contributions

Contribution types and limits are the same as those for 401(k) profit-sharing plans, with a “safe harbor” exception. To qualify for the exception, employers must make a 100% vested contribution of either:

  • 3% of compensation for each eligible employee
  • A matching contribution of up to 4% of compensation

The safe harbor then permits owners and other highly compensated employees to defer the maximum without regard to the deferral levels of employees who are compensated less.

Advantages of a 401(k) Safe Harbor Plan

In addition to the advantages offered by a 401(k) profit-sharing plan, the Safe Harbor 401(k) avoids the nondiscrimination testing that may limit the amounts highly compensated employees may defer.