401(k)ology – Profit Sharing Allocations: Who Gets What and Why It Matters

Let’s be honest, when most people hear “profit sharing,” they picture a magical moment where their employer suddenly showers them with extra retirement dollars. And while that can happen (cue confetti), the real magic is in how those dollars are divvied up. Spoiler alert: not all methods are created equal.

One of the most popular methods of attracting and retaining talented employees (and passing nondiscrimination testing) is offering a matching contribution in the company 401(k) plan. The employee sets aside money through payroll deduction (deferrals), and the company matches those deferrals at a set percentage or dollar amount. The catch? In order to get the match, the employee must contribute to the plan. However, there is another (less mainstream) type of employer contribution that does not require employee deferrals - the “profit sharing” contribution.

According to the Plan Sponsor Council of America’s 2024 annual survey report, more than 80% of 401(k) plans fund a company match while roughly 44% provide a non-matching (profit sharing) employer contribution. About 36% of plans provide both, while less than 10% provide profit sharing only. As 401(k) plans have grown in popularity, the data seems to suggest that companies have slowly moved away from profit sharing contributions, choosing instead to provide employer contributions solely to those that elect deferrals.

However, with roughly 44% of employers providing a non-matching employer contribution, it is important to understand how these profit sharing contributions are allocated to participants and the reasoning behind each type of allocation method. Perhaps employers and retirement committees have focused on matching contributions because that is the trend in 401(k) plans, but profit sharing type contributions should not be overlooked.

In this post, we’re diving into the different ways employers can allocate profit sharing contributions in a 401(k) plan, including the pros and cons to each method.

Profit Sharing Allocation Methods

Before kicking off the various allocation methods, a lesson in retirement plan terminology. Profit sharing contributions may also be called “non-elective” contributions. Elective contributions are amounts an employee elects to defer from their paycheck (e.g., 401(k) or 403(b) salary deferrals). Non‑elective contributions are employer‑funded amounts made regardless of any employee election, of which profit sharing contributions fall into this category. So, you may interchange “profit sharing” and “non-elective” when discussing these employer funded contributions.

Odd as this sounds, “profit sharing” doesn’t require actual profits. A profit sharing plan is just a plan type with non-elective contributions made by the employer. Similarly, a 401(k) profit sharing plan is just a 401(k) plan (i.e., cash or deferred arrangement that allows employees to choose to contribute) that includes profit sharing (i.e., employer non-elective contribution) provisions. In fact, 403(b) plans frequently provide profit sharing contributions even though the entity is a non-profit organization.

Regardless of the type of plan or what it is called, let’s focus on how the employer contributions are divvied up among the eligible employees by breaking them down as follows:

1. Pro Rata (Comp-to-Comp): The “Fair and Square” Method

This is the vanilla ice cream of allocation formulas - classic, simple, and everyone gets a scoop based on their salary. The employer may impose conditions to share in the allocation, like being employed on the last day of the plan year or working a certain number of hours during the plan year as long as the allocation satisfies coverage testing.

How it works: If the employer decides to contribute 5% of eligible compensation, every eligible employee gets 5% of their pay.

• Why it’s great:

  • Super straightforward

  • No fancy math

  • Everyone feels included

  • Popular with non-profit organizations

• Why it might not be great:

  • Doesn’t help owners or highly compensated employees (HCEs) maximize their savings

2. Flat Dollar: The “Everyone Gets the Same” Method

This one is as egalitarian as it gets. Every eligible employee receives the same dollar amount, regardless of their compensation.

How it works: If the employer contributes $1,000, everyone gets $1,000. Period.

• Why it’s great:

  • Promotes equality

  • Easy to explain and administer

• Why it might not be great:

  • Doesn’t account for income differences

  • May not align with retirement needs

3. Integrated (Permitted Disparity): The “Social Security” Method

This one’s a bit more nuanced. It recognizes that Social Security replaces a higher percentage of income for lower earners, so it allows employers to give a little extra to those earning above the Social Security wage base.

How it works: Contributions are split with one rate for compensation below the Social Security wage base and a higher rate for earnings above it.

• Why it’s great:

  • Aligns with Social Security retirement benefits

  • Can benefit higher earners without fancy testing required

• Why it might not be great:

  • More complex to explain

  • May raise eyebrows among lower-paid employees

For math brains, the calculation can be 5% of total eligible compensation plus another 5% of compensation above the Social Security taxable wage base in effect for the year. It may also be structured to recognize a portion of the wage base rather than the full wage base.

4. New Comparability (Cross-Tested): The “Custom Fit” Method

Ah, the tailor-made suit of profit sharing. This method lets employers create employee groups (like owners, managers, staff, partners, associates) and allocate contributions differently across those groups. This method is quite popular in professional service industries (medical, dental, architectural and legal).

How it works: Instead of equal slices, contributions are tested based on projected retirement benefits. Think of it as a retirement crystal ball. The contributions allocated today are projected to normal retirement age so that older employees closer to retirement can get a larger share without breaking any rules.

• Why it’s great:

  • Highly customizable

  • Can favor HCEs close to retirement

  • Can pair with a 401(k) safe harbor non-elective contribution in testing (double dip!)

• Why it might not be great:

  • Requires special nondiscrimination testing

  • Needs actuarial type expertise

  • Young HCEs can wreck the test results

  • Smaller “minimum allocation gateway” contribution for non-HCEs can create major disparities

5. Age-Weighted: The “Catch-Up for the Older Crowd” Method

This method says, “Hey, you’re closer to retirement, let’s help you get there.” Contributions are based on both age and compensation.

How it works: Older employees get a larger share because they have fewer years to save.

• Why it’s great:

  • Aligns with retirement timelines

  • Great for businesses with older owners or key staff

• Why it might not be great:

  • Younger employees might feel left out

  • Requires more math (again with the math!)

  • Not very intuitive for participants because allocations can vary with actuarial factors

6. Uniform Points: The Age + Longer Tenured Method

This method combines age and service but may include a compensation piece. While it may not seem logical, this method is more straightforward (at least in the calculation) than the age-weighted allocation.

How it works: Each participant is assigned “points” based on objective factors (most commonly age and service; sometimes compensation). The employer’s total profit‑sharing contribution is divided across participants in proportion to each person’s points.

• Why it’s great:

  • Aligns with retirement timelines

  • Great for businesses with longer tenured owners or key staff

  • Participants can more easily understand the allocation method

• Why it might not be great:

  • Less tenured employees will get a smaller share

  • Only provides a slightly greater tilt toward older and longer tenured employees

Allocation Conditions

Below is a practical overview of common “allocation conditions” employers use to determine who shares in a discretionary profit sharing contribution under a 401(k) profit sharing plan. These apply after a person is otherwise eligible and has entered the plan (met the age/service and entry dates required under the plan provisions).

No allocation conditions: (everyone who is a participant at any time during the year shares in the allocation)

• Easiest to administer; lowest risk of operational errors

• Employee-friendly; supports morale and retention messaging

• Easiest path to satisfy coverage and nondiscrimination testing

• Highest cost because terminated and short-service participants also receive allocations.

• Less effective as a retention tool

Last-day-of-plan-year rule: (must be employed on the last day of the plan year, e.g., 12/31, to receive any allocation)

• Strong retention incentive; limits expense for turnover

• Simple rule to communicate and administer if payroll/HRIS can verify status on one date

• Can feel punitive to mid‑year terminations, including involuntary layoffs

• Greater risk of failing coverage testing if many NHCEs terminate mid-year

• May discourage employee goodwill

• Exceptions typically made for death, disability, retirement

Minimum hours requirement: (e.g., 1,000 hours of service completed in the plan year to share)

• Targets contributions to year‑long contributors, regardless of termination timing

• Requires accurate hours tracking and equivalency rules (risk of administration errors)

• Not compatible if the plan uses the “elapsed time” service method

Last-day AND minimum hours: (must meet both)

• Maximum cost control and retention leverage

• Highest employee relations risk

• Greatest pressure on 410(b) coverage and 401(a)(4) nondiscrimination testing

• Coverage failures require contributions to be allocated to those who did not satisfy both

Last-day OR minimum hours: (must meet either)

• Balanced approach: captures longer service employees who terminate before year‑end and those still employed at year‑end

• Often improves coverage testing outcomes versus the “AND” approach

• Costs are higher than the “AND” or pure last‑day approach, but still excludes short‑service participants

Employed on a specified “allocation date” (e.g., employed on the date the contribution is allocated, which could be after year‑end)

• Aligns with accounting/approval timing; creates clear point‑in‑time eligibility

• Retention tool if the allocation date is later than year‑end

• Can be confusing; participants may not realize they must continue employment post‑year‑end

• Coverage testing may fail, requiring corrections as noted above

Plans typically include exceptions or waive conditions for participants who do not work the set amount of hours or terminate employment before the end of the plan year due to the participant’s death, disability, leave of absence, or normal retirement age. Allocation conditions (and exceptions) must be stated clearly in the plan document and applied consistently in operation.

Employers should model expected costs, review coverage testing results, and determine the operational steps required before adopting or changing allocation conditions. The anti-cutback rule prohibits employers from changing the allocation conditions during a plan year if the new conditions would be more restrictive. For example, changing the allocation conditions from “no allocation conditions” to the “last day and 1,000 hours” method would not be permitted mid-year. If any eligible employee has already earned the right to an allocation under the plan provisions, the conditions cannot be changed that year to something more restrictive.

So… Which One’s Best?

That depends on your company’s goals, demographics, and budget. Want to reward long-tenured employees? Uniform points allocation might be your jam. Need to maximize owner contributions while staying compliant? New comparability cross-testing could be your best friend. And for non-profit plans, the pro rata or flat dollar methods may fit your model best. The good news? You don’t have to figure it out alone. A good plan advisor can help you choose the method that fits your business like a glove.

Conclusion

Profit sharing isn’t just about generosity, its strategy, compliance, and a little bit of psychology. Whether you’re a business owner trying to optimize your plan or an employee wondering how the sausage gets made, understanding these allocation methods is key.

Got questions? Want to see how these methods would play out in your own plan? Let’s chat. And stay tuned for the next installment of 401(k)ology, where we’ll tackle another retirement mystery with wit, wisdom, and probably more coffee.

Newfront Retirement Services’ team of advisors and service team is available to help get the sausage made or to assist you in making sausage selection, so let us know how we can help! Feel free to contact me or just connect to keep up to date on all things ERISA 401(k): Joni_LinkedIn and 401(k)ology

Helpful Links:

• 401(k)ology – Highly Compensated Employees

• 401(k)ology – Safe Harbor 401(k) Plans

• 401(k)ology – Gaps in Coverage Can Sink the Ship

• 401(k)ology – Rehired Employees: Eligibility, Vesting and Automatic Enrollment

• IRS - Choosing a retirement plan: Profit sharing plan

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