Profit Sharing Plan Contribution Limits: What You Need to Know

Profit sharing plans are a popular employee benefit, offering workers a share in the company’s profits and providing employers with a tool for attracting and retaining talent. Understanding contribution limits is crucial as they determine how much can be allocated to these plans annually. These limits influence both employees’ retirement savings and employers’ financial planning strategies. Here’s a closer look at profit sharing plan contribution limits and their implications.

Maximum Contribution Formulas

Understanding the formulas for maximum contributions to profit sharing plans is essential for both employers and employees, as they determine annual allocations based on specific factors.

Dollar-Based Limit

The dollar-based limit for profit sharing plans is governed by the Internal Revenue Code (IRC) Section 415(c). For 2023, the maximum contribution is the lesser of $66,000 or 100% of the participant’s compensation. This cap includes employer contributions, employee contributions, and forfeitures allocated to participants’ accounts. Plan sponsors must monitor contributions closely to avoid exceeding limits, which can trigger penalties and necessitate corrective actions. Annual updates from the IRS regarding these limits, adjusted for cost-of-living changes, are critical to track.

Percentage-of-Pay

The percentage-of-pay limit allows contributions up to 25% of an employee’s eligible compensation, calculated on gross salary before deductions or deferrals. Under IRC Section 404(a)(3)(A), the total deductible employer contribution cannot exceed 25% of the total compensation of all eligible employees. Businesses with fluctuating profit margins must carefully coordinate contributions to remain compliant while optimizing their benefit offerings.

Employer Discretion

Employers have flexibility in determining how contributions are allocated among employees. Contributions can be based on salary levels, tenure, or performance metrics, enabling companies to align plans with business goals. However, nondiscrimination requirements under the Employee Retirement Income Security Act (ERISA) ensure plans do not disproportionately favor highly compensated employees. Annual nondiscrimination testing helps employers meet IRS standards and maintain compliance.

Multiple Plan Coordination

Managing multiple retirement plans within one organization can be challenging, especially when coordinating profit sharing plans with other retirement vehicles like 401(k)s or defined benefit plans. Each plan has unique rules and contribution limits. For example, combined contributions for all defined contribution plans, including profit sharing and 401(k)s, cannot exceed the lesser of $66,000 or 100% of the participant’s compensation for 2024. Employers must track contributions carefully to ensure appropriate distribution across plans.

Additionally, nondiscrimination testing across all plans is critical to avoid favoring highly compensated employees. Noncompliance can result in penalties and require corrective measures. Employers must also account for catch-up contributions for employees aged 50 and older, which further complicates coordination efforts.

Excess Contribution Adjustments

When contributions exceed allowable limits, prompt correction is necessary to avoid penalties and maintain compliance with IRS regulations. Identifying the source of the excess—whether due to miscalculations, changes in compensation, or coordination issues with other plans—is key to determining the appropriate corrective strategy.

Corrective actions may include distributing excess amounts back to employees or recharacterizing contributions to fit within allowable limits. For instance, excess contributions in a 401(k) component of a profit sharing plan may be returned to the employee as taxable income. Corrections must adhere to IRS deadlines, typically within two and a half months after the plan year ends, to avoid excise taxes of up to 10% on the excess amount.

Tax Considerations

Profit sharing plans offer significant tax advantages for both employers and employees. Employer contributions are generally tax-deductible under IRC Section 404, reducing taxable income while enhancing employee retirement benefits. For employees, contributions grow tax-deferred, allowing for compounded growth until withdrawal. However, withdrawals are subject to ordinary income tax, and those taken before age 59½ may incur an additional 10% early withdrawal penalty unless specific exceptions apply. Proper planning around distribution timing and methods can maximize tax efficiency and retirement income.