Are 401(k) Profit-Sharing Contributions Really Taxable? – Avoid This Mistake + FAQs

Planning a 401(k) profit-sharing contribution strategy requires understanding how these contributions are taxed. This topic is critical for business owners, HR professionals, accountants, financial advisors, and general taxpayers.

Are 401(k) profit-sharing contributions taxable? In most cases, these contributions offer tax-deferred benefits—meaning they are not immediately taxable to employees when contributed.

However, the details can vary across different 401(k) plan types and recent tax law changes (including 2024 updates) that may affect their treatment.

Understanding 401(k) Profit-Sharing Contributions

A 401(k) profit-sharing contribution is an employer’s discretionary contribution to employees’ retirement accounts within a 401(k) plan. Despite the name “profit-sharing,” a company doesn’t actually need to have a profit in a given year to make this contribution – it’s essentially a bonus paid into a retirement plan rather than as cash.

Employers can decide annually whether to contribute and how much (within IRS limits), often based on company performance or strategic reward goals. These contributions are allocated to employees’ 401(k) accounts according to the plan’s formula (for example, as a percentage of salary or a flat dollar amount per person).

Importantly, profit-sharing contributions to a 401(k) are employer contributions, not taken from an employee’s paycheck. They are in addition to any employee salary deferrals or matching contributions.

Many plans allow profit-sharing in conjunction with employee 401(k) deferrals – for instance, a plan might let employees contribute from their salary and also give the employer the option to add a profit-sharing amount at year-end. Some 401(k) plans are even designed primarily as profit-sharing plans with a 401(k) feature, meaning the profit share is the main employer contribution mechanism.

Are 401(k) Profit-Sharing Contributions Taxable to Employees?

Short answer: No, 401(k) profit-sharing contributions are not taxable to employees in the year the contribution is made.

When an employer contributes profit-sharing dollars into your 401(k) account, you do not pay federal income tax on that money at the time of contribution. Unlike a cash bonus that would be included in your W-2 wages and taxed immediately, a profit-sharing contribution goes into a qualified retirement trust, so it escapes current taxation.

This is a key tax benefit of 401(k) plans – contributions (and any investment earnings on them) are tax-deferred until you withdraw the money in the future.

From the employee’s perspective, profit-sharing contributions do not show up as taxable income on your tax return for that year. For example, if your employer contributes an extra $5,000 into your 401(k) as a profit-sharing contribution in 2024, your taxable wage income for 2024 remains the same as if that $5,000 had not been paid to you at all. You won’t pay income tax on that $5,000 until you take distributions from the 401(k), typically at retirement.

It’s also worth noting that these employer contributions are not subject to payroll taxes like Social Security and Medicare. Because profit-sharing amounts aren’t part of your wages, no FICA taxes are withheld on them. This contrasts with a cash bonus of $5,000, which would incur a 7.65% FICA withholding for the employee (and another 7.65% payroll tax cost for the employer). In other words, profit-sharing contributions avoid both income tax and payroll tax at the time of contribution, making them a very tax-efficient form of compensation for employees.

To illustrate the difference in tax treatment, consider the following comparison of receiving $5,000 as a profit-sharing 401(k) contribution versus a $5,000 cash bonus:

In this example, the profit-sharing contribution yields no tax cost in the current year, whereas a cash bonus of the same amount results in immediate tax withholding. Over time, the $5,000 in the 401(k) can grow tax-deferred. When you eventually withdraw it in retirement (say it has grown to a larger amount), the withdrawals will be taxed as ordinary income under IRS rules (assuming the contribution was pre-tax). If you withdraw before age 59½, it may also be subject to a 10% early withdrawal penalty unless an exception applies.

Tax-Deferred Growth and Future Taxation

While profit-sharing contributions aren’t taxed up front, they are not tax-free forever. They enjoy tax-deferred growth in the 401(k) account. You’ll pay taxes later when you take distributions from the plan. Under Internal Revenue Code §402(a), distributions from a qualified plan are generally included in the recipient’s taxable income (except for any portions that represent after-tax contributions or qualified Roth distributions). In practical terms, that means when you retire and start withdrawing your 401(k) money (including amounts that originated as profit-sharing contributions plus any investment gains), those withdrawals are subject to income tax at your then-current tax rate.

However, because many people have lower income in retirement, they might be in a lower tax bracket when the funds are taxed. Also, by deferring tax, you benefit from compounding growth on the pre-tax amount. For example, if $5,000 grows to $15,000 over time in the plan, you’ll eventually pay tax on the $15,000 at withdrawal. Had that $5,000 been taxed and only $3,500 invested after tax, your compounded growth would be on a smaller base.

In summary, for employees, 401(k) profit-sharing contributions function like any pre-tax retirement contribution: not taxable now, but taxable later when withdrawn. This is essentially the same tax treatment as your traditional 401(k) salary deferrals or employer matching contributions.

What If the Contribution Is to a Roth 401(k)? (2024 Update)

Historically, all employer contributions (including profit-sharing and matching) in a 401(k) had to be made on a pre-tax basis for employees. Even if you chose to make Roth (after-tax) elective deferrals from your salary, any employer contributions still went into the pre-tax portion of your account. However, starting in 2024, there is a new option introduced by the SECURE 2.0 Act of 2022: employers may allow participants to elect that their employer contributions be treated as Roth contributions.

If your plan implements this feature, a profit-sharing contribution could effectively be made as a Roth 401(k) contribution in your account. The catch is that Roth contributions are taxable upfront. So, if you choose this option, the contribution will be included in your gross income (and likely on your W-2) in the year made. In other words, you’d pay income tax on the value of the contribution now, in exchange for having that money grow tax-free and be potentially tax-exempt at retirement (since qualified Roth withdrawals are tax-free).

Example: Suppose in 2024 your employer allocates a $5,000 profit-sharing contribution to you. If you do not have the Roth option (the traditional case), you pay no tax now – the $5,000 goes in pre-tax. If you elect Roth treatment and the plan allows it, that $5,000 would be added to your taxable wages for 2024. You’d pay tax on it (say $1,100 if 22% bracket), but the $5,000 still goes into your Roth 401(k) account to grow tax-free. Down the road, qualified withdrawals from that Roth 401(k) portion (including earnings) would be tax-free. Essentially, it switches the timing of taxation: pre-tax = no tax now, tax later; Roth = tax now, no tax later.

One important consideration: If treated as Roth, those employer contributions likely are subject to payroll taxes and withholding just like a bonus, since they become part of your taxable wages. The IRS has issued guidance (under SECURE 2.0’s Section 604) noting that designated Roth employer contributions are includable in income when made. Employees must be 100% vested in these contributions for the Roth option. This 2024 update is still rolling out, and not all plans will adopt it immediately. Check with your plan sponsor to see if Roth employer contributions are available.

In summary, under a traditional approach, 401(k) profit-sharing contributions are not taxable to employees when contributed (tax is deferred). Under a Roth treatment (new in 2024), they would be taxable in the contribution year, but then future growth and withdrawals become tax-free. The vast majority of plans currently treat profit-sharing in the traditional pre-tax manner.

How Do 401(k) Profit-Sharing Contributions Affect Employer Taxes?

Profit-sharing contributions have significant tax implications for employers as well. For businesses, these contributions are generally tax-deductible expenses. When a company contributes to employees’ 401(k) accounts, it can deduct those contributions on its corporate (or business) tax return, reducing the company’s taxable income. This is a major incentive for companies to offer retirement contributions: they reward employees and get a break on taxes at the same time.

Under IRC §404(a), employers can deduct contributions to qualified retirement plans (like a 401(k) profit-sharing plan) up to certain limits. For defined contribution plans (including 401(k)s), the deductible limit is typically 25% of the compensation paid to all eligible participants. In practical terms, the total of all employer contributions (profit-sharing + match, etc.) for all employees cannot exceed 25% of the aggregate compensation of those employees for the year. If contributions exceed that, the excess isn’t deductible that year (and may incur an excise tax if not corrected).

However, most small and mid-sized companies do not hit that 25% ceiling. To give a sense of scale: if a company has a total payroll of $1,000,000, it can generally deduct up to $250,000 of employer contributions for that year. For 2024, the IRS “annual additions” cap (under IRC §415) limits each individual’s total contributions (employee + employer) to $69,000 (or $76,500 if age 50 or older, including catch-up contributions). So, the 25% limit and the individual limit both apply. Usually the 25% of payroll limit is the controlling factor for deductibility, while the per-person $69k limit controls how much an individual can receive.

Employer Tax Savings Example: Imagine your business (a C-corporation) had a good year and you decide to allocate $60,000 as a profit-sharing contribution across employees. This $60,000 is a business expense. If your corporate tax rate is 21%, deducting $60,000 saves about $12,600 in federal corporate tax (0.21 * $60,000). The company also avoids payroll tax on that $60,000 because it wasn’t paid as wages. Had that $60,000 been paid as bonuses to employees instead, the company would owe 7.65% in employer Social Security/Medicare taxes (~$4,590) on top of the wages, and employees would owe the same from their end. By using a profit-sharing contribution, the business gets the deduction and sidesteps that additional payroll tax cost.

From a cash flow perspective, profit-sharing contributions can be made after year-end but still count for the prior tax year, as long as they are deposited by the business’s tax filing deadline (with extensions). For instance, a calendar-year company could decide in February 2024 to make a profit-sharing contribution for the 2023 plan year and deduct it on the 2023 tax return (filed by March or April 2024, depending on entity type). The U.S. Tax Court in Don E. Williams Co. v. Commissioner (1974) affirmed the rule that accrual-basis taxpayers can deduct a contribution for the prior year if it’s paid by the tax return due date. So businesses have flexibility in timing the funding for cash flow purposes, while still securing a prior-year deduction.

It’s important for employers to adhere to IRS rules when deducting these contributions. Overstepping the 25% of compensation limit can lead to a 10% excise tax on the excess contribution amount, and that excess must be carried forward to deduct in a later year. Also, contributions must be made to a proper qualified plan trust. In one Tax Court case, a sole proprietor attempted to deduct a large “profit-sharing” payment but was denied because the plan wasn’t properly established – a reminder that you need a valid plan and trust in place to get the tax benefits.

To summarize employer tax treatment:

• Deductible Expense: Profit-sharing contributions are generally 100% deductible to the business (within limits), directly reducing taxable income.
• Payroll Tax Savings: They are not treated as wages, so the company does not pay Social Security or Medicare taxes on these amounts.
• Limits: Cannot exceed 25% of aggregate participant compensation (and cannot exceed the per-employee annual addition cap, which is $69k for 2024). Most typical profit-sharing contributions (often 5-10% of pay) stay well below these limits.
• Timing: Contributions for a year can be made up until the business’s tax filing deadline (for example, until April 15, 2025, for 2024 contributions by a sole proprietor, or March 15, 2025, for an S-corp without extension), allowing retroactive tax planning.
• Proper Plan Required: The plan must comply with IRS qualification requirements. If a plan fails to remain qualified (for instance, not amended for law changes or failing nondiscrimination tests), deductions might be disallowed and employees could be taxed currently on contributions. (Christy & Swan Profit Sharing Plan v. Commissioner, T.C. Memo 2011-62, is a case where a plan lost its tax-qualified status for failing to update, demonstrating the importance of compliance.)

Safe Harbor 401(k) Profit Sharing: Any Different Tax Treatment?

Safe Harbor 401(k) plans are a type of 401(k) that automatically satisfies certain IRS discrimination tests by requiring fixed employer contributions (either a matching formula or a 3% of pay nonelective contribution to all employees). From a tax standpoint, safe harbor contributions – whether they are matching or nonelective – are treated very similarly to profit-sharing contributions. They are not taxable to the employee when made and are deductible to the employer (subject to the same 25% of payroll limit, which in practice usually isn’t an issue since safe harbor contributions tend to be around 3-4% of pay).

Often, employers offering a safe harbor 401(k) may still add an additional profit-sharing contribution on top. The safe harbor part may be mandatory, but any extra profit sharing is discretionary. All employer contributions in a safe harbor plan (both the required safe harbor and any additional profit sharing) enjoy the same tax deferral for employees. The key difference with safe harbor contributions is that they must be 100% vested immediately (by law), whereas discretionary profit-sharing contributions in a regular 401(k) can be subject to a vesting schedule. Vesting does not affect taxation timing, but it affects who gets to keep the money if an employee leaves early. For employees, vested or not, they don’t owe tax on contributions at the time of contribution; if they forfeit unvested amounts upon leaving, that never becomes their taxable income at all.

In short, being a “safe harbor” plan does not change the fundamental tax status of contributions. It just ensures the plan stays qualified by giving employees a guaranteed contribution. Safe harbor 401(k) profit-sharing contributions are not taxable to employees when contributed and remain subject to tax only at distribution, just like in a traditional 401(k) plan. The employer can deduct them just like any other employer contribution.

Roth 401(k) Profit Sharing Contributions and 2024 Tax Changes

We touched on this earlier, but let’s emphasize this new development. Traditionally, Roth 401(k) referred only to the portion of your own salary deferrals that you choose to designate as after-tax Roth. Employers historically could not put money into your Roth 401(k) – all their contributions went into the tax-deferred bucket. The 2024 update (from SECURE 2.0) now gives an option for Designated Roth Employer Contributions. This means profit-sharing (or matching) contributions can be designated as Roth if the plan and participant allow.

Tax impact: If a profit-sharing contribution is designated as Roth, it is taxable to the employee in the year of contribution (yes, we keep repeating because this is a big change). The employer cannot take a tax deduction for a Roth contribution for itself because, effectively, it’s not excludable from the employee’s income – but here’s a nuance: the IRS still treats the payment as a business expense (wages), so the employer should still be able to deduct it as compensation paid (just like a bonus). It simply doesn’t get the specialized “benefit plan contribution” deduction since it’s now wages. In other words, it shifts the deduction from line for “pension contribution” to the regular salary deduction line, but the tax outcome (deductible to employer, taxable to employee) holds.

For employees, a Roth 401(k) employer contribution means you’ll see that amount in your wages, pay tax now, and then it goes into a Roth account in your 401(k). That Roth account’s earnings and future distributions can be tax-free if you meet the qualified distribution rules (age 59½ and 5-year rule, etc.). Another benefit: unlike pre-tax 401(k) money, Roth 401(k) accounts (including Roth employer contributions under this new rule) will not be subject to required minimum distributions (RMDs) starting in 2024, thanks to SECURE 2.0 eliminating RMDs on employer Roth accounts. So Roth contributions have long-term estate planning advantages too.

This new Roth treatment is optional and must be offered by the plan. Many employers may take time to add this feature (if at all). It’s more administrative work (and employees may or may not want the immediate tax hit). But it’s a noteworthy change for 2024: it’s now possible for profit-sharing contributions to be taxable immediately (if done as Roth). If you don’t elect Roth or your plan doesn’t offer it, then nothing changes – your profit-sharing contributions remain pre-tax/tax-deferred.

Key takeaway: As of 2024, ask your plan administrator if you have the option to take employer contributions as Roth. If you’re in a low tax bracket now (and expect higher in retirement), you might consider paying the tax now via a Roth employer contribution. High earners, on the other hand, often prefer the immediate tax break of pre-tax contributions. In any case, the availability of Roth employer contributions adds flexibility in tax planning around profit sharing.

Solo 401(k) Profit Sharing: Self-Employment Tax Benefits

A Solo 401(k) (also known as an individual 401(k)) is a 401(k) plan covering a business owner with no employees (other than possibly a spouse). Solo 401(k) plans allow the person to contribute in two capacities: as an employee (making elective deferrals from their earnings) and as an employer (making a profit-sharing contribution).

For self-employed individuals (sole proprietors, single-member LLCs, partners in a partnership, etc.), the profit-sharing contribution is calculated a bit differently due to how self-employment income works. Essentially, if you’re self-employed, you don’t have “W-2 wages” yourself; instead, your business profits are your compensation. The IRS provides a formula that effectively limits the profit-sharing contribution to 20% of your net self-employment earnings (because you must account for the fact that contributing reduces your earnings for calculating the 25% limit). For owners who pay themselves via W-2 (e.g., an S-corp owner who is also an employee), the limit is a straightforward 25% of W-2 wages.

From a tax perspective, solo 401(k) profit-sharing contributions follow the same rules: they are tax-deductible to the business/owner and not taxable to the owner personally at the time of contribution. If you’re a sole proprietor, the contribution is deducted on your Form 1040 (Schedule C or an adjustment to income) as a retirement plan contribution, which in turn lowers both your income tax and your self-employment tax. This is an important point: making a profit-sharing contribution as a self-employed person can reduce your self-employment (Social Security/Medicare) taxes, because it lowers your net profit.

For example, Jane is a consultant with Schedule C income of $100,000 in 2024. She opens a solo 401(k). She could defer up to $23,000 as her own 401(k) contribution (assuming she hasn’t got other 401k deferrals) and also contribute as “employer” up to around 20% of her net profit. Suppose her net profit after deducting the employer contribution is $80,000; she could contribute roughly $20,000 as the profit-sharing portion. That $20,000 reduces her taxable income and reduces the amount subject to the 15.3% self-employment tax. In effect, she’s shifted $20,000 of income into a sheltered account, saving income tax and about $3,060 of self-employment tax (15.3% of 20k) for the year. The $20,000 grows tax-deferred in her 401(k). When she withdraws it decades later, she’ll pay regular income tax, but she never has to pay the 15.3% SE tax on that amount.

Solo 401(k) plans follow the same annual contribution limits. In 2024, Jane’s total contributions cannot exceed $69,000 (since she’s under 50) between her deferral and profit share. As both employee and employer, she has flexibility: she could max her employee deferral $23,000, and then her profit share limit would fill the rest up to $69,000 if her income is high enough. The combination of deferral and profit share for self-employed is often described as: up to $23,000 (2024) as employee + approx 20% of net self-employment income as employer, with the total capped at $69,000.

The tax benefit for a solo 401(k) owner is huge: they effectively can shelter a large portion of their income from current tax. This not only lowers their federal (and state) income tax but also their self-employment tax as noted. No profit-sharing contribution = more taxable profit = more SE tax. So it’s an excellent strategy for one-person businesses to save aggressively for retirement while cutting their tax bill.

In summary, solo 401(k) profit-sharing contributions are not taxable to the owner at contribution time and are deductible to their business. They follow the same deferral-until-withdrawal principle. The main difference is calculating the allowable amount, and the added benefit of reducing self-employment taxes. Just like any other 401(k), withdrawals in retirement from the pre-tax portion will be taxable as income. (Solo 401(k) plans can also offer Roth subaccounts, but the employer contribution portion for a self-employed person would normally be pre-tax, unless they opt into the new Roth treatment we discussed.)

Examples: How Profit-Sharing Contributions Impact Taxes (With Calculations)

To make the concepts more concrete, let’s look at a few hypothetical tax scenarios involving 401(k) profit-sharing contributions:

Scenario 1: Employee vs. Bonus
Maria is a project manager earning a $80,000 salary. Her employer is considering giving her an additional year-end reward of $8,000. They could either (a) give her an $8,000 cash bonus, or (b) contribute $8,000 into her 401(k) as a profit-sharing contribution. Here’s how the tax outcomes differ:

• Cash Bonus: $8,000 would be added to Maria’s W-2 wages. Assume Maria is in the 22% federal tax bracket and 5% state tax bracket. Immediately, about 27% ($2,160) might be withheld for taxes. She also pays 7.65% FICA ($612). Maria’s take-home from the bonus might be around $5,228. The employer can deduct $8,000 as a wage expense, but also has to pay $612 in employer FICA. Maria will owe income tax on the bonus when she files (though withholding covered most of it), and the bonus is fully taxable in 2024.

• 401(k) Profit-Sharing: $8,000 goes into Maria’s 401(k). She pays zero income tax on it this year and no FICA on that contribution. Her W-2 doesn’t include that $8,000 as income at all. The employer deducts $8,000 as a retirement plan contribution. Maria’s take-home pay isn’t increased now, but she effectively has $8,000 more saved for retirement. That $8,000 can grow. Suppose in 30 years it’s worth $50,000. When Maria withdraws it at age 65, if she’s in the 22% bracket then, she’d pay tax on the distribution (roughly $11,000 on $50k withdrawal). But she got to invest the full $8k pretax for decades. Meanwhile, she didn’t pay the $2,160 + $612 in taxes upfront, which effectively was a big immediate gain.

Result: Maria didn’t get extra money in hand now with the profit-sharing, but for long-term wealth, the tax deferral is powerful. It’s essentially the difference between investing $8,000 vs. $5,228 for her future – the pre-tax route allowed a larger sum to grow.

Scenario 2: Small Business Owner’s Deduction
John owns a small company (an S-corporation) with 3 employees. The total payroll (including his own salary) is $300,000 for 2024. The business had a successful year and wants to allocate $30,000 as profit-sharing contributions (10% of each employee’s salary). John’s own salary is $120,000, so he would get $12,000 of that contribution to his account; the other $18,000 goes to his employees’ accounts proportionally.

• The business can deduct the full $30,000 on its 2024 corporate tax return. If the S-corp’s income before the contribution was $100,000, it will now report $70,000 taxable (saving $30k from being passed through to John’s personal K-1 income). If John’s personal tax rate is around 32%, that deduction saves him about $9,600 in federal taxes on his pass-through income.
• Neither John nor his employees see any of that $30,000 in their immediate taxable wages. None of them pay income tax or FICA on those contributions in 2024.
• The company also saved about $2,295 in employer payroll taxes (7.65% of $30k) that it would have paid if that $30k had been wages instead.
• Down the road, John and his employees will pay taxes on distributions of that money, but presumably when they use it in retirement.

This scenario shows how a profit-sharing contribution simultaneously reduces the owner’s current taxes and provides a benefit to employees that is tax-deferred for them. It’s a win-win in terms of tax efficiency (though it costs the company cash to fund the contributions, of course).

Scenario 3: Exceeding Limits (What Not to Do)
ABC Corp has a very generous CEO who wanted to maximize contributions in 2024. The company has two employees: the CEO earning $300,000 and one staff member earning $50,000. The CEO tries to contribute $100,000 to the 401(k) plan for himself and $5,000 for the staff member, totaling $105,000 in employer contributions.

• Deduction limit check: The total eligible compensation is $350,000. 25% of that is $87,500. The company’s $105,000 contribution exceeds the deductible limit by $17,500. That excess cannot be deducted in 2024. The company would only be allowed to deduct $87,500. The remaining $17,500 could be carried over to deduct in future years, but in the meantime, the IRS could impose a 10% excise tax on the nondeductible contribution.
• Annual additions check: For the CEO, contributions cannot exceed $69,000 for 2024. If the CEO already maxed his own salary 401(k) deferral ($23,000) and got a $100,000 profit-sharing, that’s $123,000 total, which far exceeds $69,000. The plan would be out of compliance. The excess would require correction (possibly refunding or recharacterizing the overage), and the tax benefits could be jeopardized.
• Outcome: Over-contributing is a costly mistake. The IRS could disqualify the plan if such errors aren’t corrected, which might make all contributions immediately taxable to the employee. The CEO’s enthusiasm to save on taxes backfired by breaking the rules.

This scenario underscores why sticking to IRS limits is crucial. The tax benefits of profit-sharing contributions only apply if you operate within the allowed parameters. If you keep contributions within the limits (both per-employee and overall), you avoid these pitfalls.

Scenario 4: Roth vs Pre-tax Choice (2024 forward hypothetical)
Lisa is 40, and her employer in 2024 allowed Roth treatment of profit-sharing. Lisa’s salary is $100,000. The company will contribute $10,000 profit-sharing (10% of pay). She can either take it pre-tax or elect Roth.

• Pre-Tax Route: Lisa’s 2024 taxable income remains $100,000. She pays no tax on the $10k now. The full $10k is invested in her 401(k) pre-tax. In 25 years, it might grow to $50k, which she’ll pay tax on when withdrawing.
• Roth Route: Lisa chooses Roth. Her W-2 income becomes $110,000 (the $10k is added). Assuming a 24% federal tax bracket, she’ll owe $2,400 more in income tax for 2024 (plus state tax). That $10k goes into her Roth 401(k) account. In 25 years, it grows to $50k. At retirement, she can withdraw that $50k tax-free (since it’s qualified Roth money).
• If Lisa expects to be in a higher tax bracket later or believes tax rates will rise, she might prefer the Roth. If she wants the tax break now, she’ll stick to pre-tax. Either way, the employer still paid $10k on her behalf; the difference is when Uncle Sam takes his cut.

This scenario shows how the timing of taxation can be managed under new rules. Regardless of choice, the money is in a retirement account – either growing tax-deferred or tax-free.

IRS Rules and Key Court Cases on 401(k) Profit Sharing

To ensure we’re approaching this topic at an expert level, let’s reference some IRS regulations and legal framework that govern the taxation of 401(k) profit-sharing contributions:

• Internal Revenue Code §401(a) & §501(a): These provisions establish qualified retirement plans and their tax-exempt trust status. A profit-sharing 401(k) plan meeting these requirements has a trust that is exempt from tax. This is why the earnings in your 401(k) grow without current tax – the trust itself isn’t taxed (unlike a regular investment account).

• IRC §402(a): Dictates that distributions from a qualified plan are taxable to the distributee in the year of distribution (unless rolled over or otherwise exempt). This underpins the “taxed at withdrawal” rule for pre-tax 401(k) contributions. In essence, it’s why you don’t pay tax at contribution – because the Code says you pay when it comes out, not when it goes in.

• IRC §404(a)(3): Governs the employer’s deduction for contributions to a stock bonus or profit-sharing plan (including a 401(k) plan). It generally limits the deductible amount to 25% of the participants’ aggregate compensation. There are special rules if the employer sponsors both a defined contribution and defined benefit plan, but for most, 25% is the key limit. (Elective deferrals by employees don’t count toward that 25% for deduction purposes, which is why an employer can deduct those even if they exceed the percent; however, elective deferrals are limited separately by §402(g) – $23,000 in 2024).

• IRC §415(c): Sets the annual addition limit per participant. For 2024, this is $69,000 (or 100% of compensation, if less). This is why even a very high earner can’t get more than $69k combined contribution (or $76.5k if age 50+ including catch-up). Profit-sharing contributions fall under “annual additions.” The law ensures extremely large contributions don’t all go to one person in a single year beyond this cap.

• IRC §3121(a): Part of the Social Security tax code, which defines “wages” for FICA tax. Employer contributions to a qualified retirement plan are excluded from the definition of wages. This legally supports why neither employer nor employee pays payroll taxes on profit-sharing contributions.

• IRS Regulations and Publications: IRS Publication 560 (Retirement Plans for Small Business) provides guidance on how to calculate and deduct contributions, especially for self-employed. It explains the 25% vs 20% (self-employed) calculation. Additionally, IRS retirement plan regulations require that plans cannot discriminate in favor of highly compensated employees. Profit-sharing contributions often must be allocated in a nondiscriminatory way (or use cross-testing rules) to pass testing. If a plan fails testing and doesn’t correct, the plan’s qualified status can be at risk.

• Key Court Case – Don E. Williams Co. v. Commissioner, 429 U.S. 569 (1977): This Supreme Court case confirmed that an accrual-basis employer could deduct a contribution for the prior year as long as it was paid by the time the tax return was due (with extensions). It’s a foundational case that clarified timing for deductions and effectively blessed the common practice of funding by the tax deadline.

• Key Court Case – Christy & Swan Profit Sharing Plan v. Commissioner, T.C. Memo 2011-62: In this Tax Court memorandum decision, the court upheld the IRS’s revocation of a plan’s qualified status because the plan sponsor failed to adopt required amendments (the plan was “frozen” and not updated for law changes). As a result, the plan lost its tax-exempt trust status. This serves as a cautionary tale: if a plan is disqualified, contributions might no longer be protected from current taxation and the employer could lose deductions. Always keep your plan documents current with law changes (like the SECURE Act updates).

• ERISA and Other Considerations: While not directly about taxation, it’s worth noting that profit-sharing contributions are subject to ERISA guidelines. For example, they can be subject to vesting schedules and must follow fiduciary rules (the money must be deposited timely into the plan trust). Late deposits, while often an operational mistake for elective deferrals, aren’t usually an issue for profit-sharing since they’re done in a lump sum. But the law generally expects deposit by the tax deadline.

In sum, the legal framework strongly encourages these contributions by offering tax benefits, but with conditions. Compliance with IRS rules (limits, nondiscrimination, plan document updates) is essential to maintain the tax-advantaged status. When done right, both the letter of the law (IRC sections) and numerous court rulings support that profit-sharing contributions are tax-deferred for employees and tax-deductible for employers.

Pros and Cons of Profit-Sharing Contributions

Like any financial strategy, 401(k) profit-sharing contributions have advantages and disadvantages. Here’s a breakdown:

Overall, the pros for both employers and employees are strong on the tax-saving and wealth-building side. The cons are mostly about liquidity (money is tied up until retirement) and ensuring compliance and affordability. For many businesses, the tax deduction plus happier employees (who see their 401(k) balances grow) outweigh the downsides.

Avoid These Common 401(k) Profit-Sharing Tax Mistakes

Even savvy employers and employees can stumble when it comes to retirement plan contributions. Here are some common mistakes to avoid regarding the tax aspects of 401(k) profit-sharing contributions:

• Exceeding Contribution Limits: Don’t contribute over the IRS limit (either the 25% of payroll for the company or the $69k per person limit). Excess contributions can lead to lost deductions and IRS penalties. Always calculate allowable amounts carefully.

• Missing the Funding Deadline: Remember that contributions for a tax year must be deposited by the company’s tax filing deadline (including extensions). If you miss that deadline, you lose the deduction for that year. Plan ahead and coordinate with your plan administrator so the money is contributed on time.

• Failing to Update Plan Documents: Tax laws change (e.g., the SECURE Act updates in 2020 and 2022). Ensure your 401(k) plan document is amended as required. An outdated plan can be disqualified, which could make contributions immediately taxable to employees and unwind tax benefits. Work with your plan provider or ERISA attorney to keep documents current.

• Not Testing or Reviewing Allocations: If you have a plan that allows flexible profit-sharing allocations (like new comparability or age-weighted plans), make sure contributions don’t unfairly favor owners beyond what’s permitted. Failing nondiscrimination tests might force corrective distributions (taxable to HCEs) or additional contributions to employees. Safe harbor plans avoid some tests, but if yours isn’t safe harbor, be vigilant.

• Confusing Profit Sharing with Profit Distribution: For business owners, note that a qualified profit-sharing contribution is different from simply taking profits out of the business as dividends or owner draws. Only contributions into the 401(k) plan get the special tax treatment. Don’t mistakenly think setting aside money informally is the same – it must go into the plan trust to be tax-deferred.

• Neglecting Participant Education: Employees might not realize that the profit-sharing contribution to their 401(k) is essentially “free money” with tax benefits. Ensure they understand they won’t pay tax on it now, so they don’t worry come tax time. Conversely, if you introduce a Roth employer contribution option, warn employees that it will increase their taxable income now so they aren’t surprised by a higher W-2.

• Early Withdrawal Pitfalls: While not directly about contributions, it’s a related mistake – if employees withdraw the profit-sharing money too early (before 59½ without an exception), they face income tax plus a 10% penalty. Encourage participants to leave the funds until retirement to preserve the tax advantages.

• Self-Employed Calculation Errors: If you’re self-employed, calculating your max profit-sharing contribution can be tricky (the 20% effective rule). A common mistake is to contribute 25% of your Schedule C profit, which is too high. Use IRS worksheets or a tax advisor to get the number right. Contributing too much for yourself can disqualify the deduction.

• Ignoring Required Contributions in Bad Years: If you promised a contribution (like a safe harbor nonelective or a stated formula in plan docs), you must fund it even if business profits are down, unless you properly amend or suspend the plan ahead of time. Failing to fund a required contribution can jeopardize the plan’s status. Only discretionary profit-sharing can truly be skipped in lean years.

Avoiding these mistakes ensures you fully reap the tax benefits of profit-sharing contributions without running afoul of IRS rules. When in doubt, consult a qualified retirement plan consultant or tax advisor. The IRS imposes strict rules, but with proper guidance, a 401(k) profit-sharing plan can be a smooth and extremely rewarding part of your tax and financial strategy.

FAQs

Q: Are 401(k) profit-sharing contributions taxable in the year they are made?
A: No. 401(k) profit-sharing contributions are generally not included in an employee’s taxable income for that year; they are tax-deferred until the employee withdraws the funds.

Q: Do you pay income tax on employer profit-sharing contributions to a 401(k)?
A: No. Employees do not pay income tax on employer contributions (like profit-sharing or match) when they go into the 401(k). Taxes apply later upon distribution of those pre-tax contributions.

Q: Are employer 401(k) profit-sharing contributions tax deductible for the company?
A: Yes. Employers can deduct profit-sharing contributions on their business tax return, up to IRS limits (typically 25% of eligible payroll). These contributions count as a business expense, reducing taxable income.

Q: Are profit-sharing contributions to a 401(k) subject to Social Security and Medicare taxes?
A: No. Profit-sharing contributions are not considered wages, so neither the employer nor employee pays Social Security or Medicare (FICA) taxes on those amounts at the time of contribution.

Q: Can 401(k) profit-sharing contributions be made as Roth (after-tax) contributions?
A: Yes. Beginning in 2024, some plans allow employees to elect employer contributions as Roth. In that case, yes, the contribution is included in the employee’s taxable income now (making it after-tax for future tax-free withdrawal).

Q: When are profit-sharing contributions taxed?
A: They are taxed when withdrawn from the 401(k). Yes, distributions of pre-tax profit-sharing contributions (and earnings) are taxed as ordinary income at the time you take money out (usually in retirement).

Q: Are 401(k) profit-sharing plan withdrawals taxed as ordinary income?
A: Yes. Withdrawals of pre-tax contributions and their earnings are taxed as ordinary income. (If the funds were Roth contributions, qualified withdrawals would be tax-free, but non-qualified withdrawals would have taxable earnings.)

Q: Is profit-sharing in a 401(k) taxed like a bonus?
A: No. A cash bonus is taxed immediately as wage income (with income tax and payroll tax). Profit-sharing in a 401(k) is not taxed when contributed; it’s treated as deferred compensation and taxed later, making it more tax-efficient upfront.

Q: Does a profit-sharing contribution affect an employee’s tax bracket in the current year?
A: No. Since the contribution isn’t included in current income (if pre-tax), it does not push the employee into a higher tax bracket that year. In fact, it effectively lowers what their taxable income would have been if that money were paid in cash.

Q: Can a business owner contribute the maximum to 401(k) profit sharing and also max a 401(k) deferral?
A: Yes. An owner can do both. Employee deferrals (up to $23,000 in 2024, plus $7,500 catch-up if over 50) are separate from profit-sharing. No, the combined total per person can’t exceed $69,000 (or $76,500 if 50+). So you can max your deferral and use profit-sharing to reach the overall limit.