How to Use Profit Sharing to Stay “Tax Neutral”
posted by Fisher 401(k) October 18, 2021
Profit sharing is more than a perk for business owners and employees. It’s a strategic tool that can significantly reduce your corporate tax burden. How? Let’s walk through one scenario.
Consider a 50-year old business owner whose business is thriving. When she checks in with her accountant, he tells her that her business posted a profit of $100,000 and even after maximizing her deductions, her business taxes will be $30,000 at the end of the year. After taxes, her business will keep $70,000. She doesn’t like the idea of writing a big check to the IRS and decides to use profit sharing to help her save more for retirement, reward her key employees and eliminate the need to write a check to the IRS. So, she:
- Provides herself a $64,500 profit sharing contribution. (This is the IRS maximum for 2021 for business owners 50+ and assumes she makes no personal 401(k) contribution).
- She provides $35,500 in profit sharing contributions to a few of her key employees.
Since what a business pays in profit sharing is 100% deductible from profits, she can reduce her company’s taxable income to zero, which would mean no check to the IRS. And the dollars that go into her personal 401(k) account are tax-deferred, which means she has more money to help grow her wealth.
For business owners with end of year profits, the dollars that would have been lost to taxes can be used to boost an owner’s wealth and help reward and retain key employees.
What other benefits does profit sharing offer?
A 401(k) profit sharing plan offers more than a chance to reduce your business taxes and incentivize employees.
- Annual contributions are discretionary and flexible. Your business can decide each year whether to make contributions or not. You also have the advantage of waiting to see end-of-year numbers before deciding whether to contribute. This gives you the flexibility to tailor your profit sharing strategy based on corporate profitability in any given year. You can also choose to forego any profit sharing contribution—it’s completely discretionary.
- You decide how much to contribute. Other retirement plan features do not allow you to adjust your contributions from year to year. For example, a Safe Harbor 401(k) requires an employer to pay 3% of all employees’ salary each year. In contrast, profit sharing contributions can be set up to target specific groups of employees without failing IRS nondiscrimination testing—a win-win for business owners who want to maximize their personal profit sharing allocation without worrying about failing compliance testing.
- Vesting is a tool for employee retention. You can set contributions to vest up to six years after the contribution has been made. Employees who leave before their contributions vest forfeit their unvested balance back to the plan. That’s a powerful incentive for employees to stay and collect the benefits they earned.
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