A 401(k) profit sharing plan is a single qualified retirement plan that combines two funding streams: employees defer part of their pre-tax pay through payroll, and the employer adds discretionary profit-sharing contributions on top when the business can afford them. For 2026, a participant can defer up to $24,500 of salary, and everything added to the account from all sources can reach $72,000 for the year. The pairing is popular with small and mid-sized employers because the profit-sharing side carries no fixed annual obligation.
How the Two Sides Work Together
The 401(k) portion runs through payroll. Each pay period, the employer withholds whatever percentage or dollar amount the employee has elected and deposits it into the plan’s trust. Those deferrals come out of pre-tax pay, so the tax benefit is immediate, and the employee decides how much to contribute up to the annual cap.
The profit-sharing portion is entirely the employer’s call. Unlike a traditional pension, there’s no set contribution required each year. A strong year can bring a generous allocation; a weak year can bring a small one or nothing. That flexibility is the main reason employers pick this design over one with mandatory funding. Both pools sit in a single tax-exempt trust, which keeps administrative costs lower than running two separate plans.
Contribution Limits for 2026
The IRS updates the caps for inflation each year. Three numbers do most of the work:
- Employee salary deferrals are capped at $24,500, up from $23,500 in 2025.
- Total annual additions to any one participant’s account cannot exceed $72,000, or 100% of the participant’s compensation if that’s lower. This ceiling covers the employee’s own deferrals, the employer’s profit-sharing contribution, and any forfeitures allocated in.
- Only the first $360,000 of an employee’s pay can be used to calculate contributions, even if the employee earns more.
These figures come from IRS Notice 2025-67 and apply to the calendar year.1Internal Revenue Service. 2026 Amounts Relating to Retirement Plans and IRAs
Catch-Up Contributions
Participants 50 or older by year-end can defer an extra $8,000, bringing their personal cap to $32,500. Under a SECURE 2.0 provision that took effect in 2025, participants who turn 60, 61, 62, or 63 during the year get a higher catch-up of $11,250 instead of $8,000, which lifts their maximum deferral to $35,750 for 2026.2Internal Revenue Service. Retirement Topics – 401(k) and Profit-Sharing Plan Contribution Limits Catch-ups sit outside the $72,000 annual additions cap, so older workers get real additional room.
Who Can Participate
Federal law sets a ceiling on how restrictive an employer can be. Under IRC Section 410(a), the most a plan can require is that an employee be at least 21 and have completed one year of service, meaning a 12-month period with at least 1,000 hours worked.3Office of the Law Revision Counsel. 26 U.S. Code 410 – Minimum Participation Standards An employer can be more generous, but not more restrictive.
Plans also have to pass annual nondiscrimination tests so the benefits don’t skew too far toward highly compensated employees. For 2026, an HCE is anyone who earned more than $160,000 in the prior year.4Internal Revenue Service. COLA Increases for Dollar Limitations on Benefits and Contributions The Actual Deferral Percentage test compares deferral rates between HCEs and everyone else; the Actual Contribution Percentage test does the same for employer matching money. A failed test forces the employer to either refund excess contributions to top earners or add contributions for lower-paid employees. Repeated failures, or ignoring them, can disqualify the plan and trigger immediate taxation on all the assets in it.
How the Employer Divides the Profit-Sharing Contribution
The employer’s contribution doesn’t have to be split evenly. The plan document has to specify a formula, and the choice heavily influences who benefits most:
- Pro-rata allocation gives each eligible participant the same percentage of compensation. It’s the simplest to administer.
- Age-weighted allocation gives older employees a larger share on the theory that their money has fewer years to grow. It’s often used when the owner is older than most of the staff.
- Cross-tested, or new comparability, allocation divides participants into groups and assigns each group a different rate, as long as the plan still passes nondiscrimination testing. This gives the most room to direct larger contributions toward owners and key employees.
Picking the formula is one of the most consequential decisions in plan design because it determines how much of each year’s contribution flows to the owner versus the broader workforce.
When Employees Own the Money
Salary deferrals are 100% vested immediately. Money the employee contributed from their own paycheck belongs to them from day one. Employer profit-sharing contributions are different: the plan can tie ownership to years of service using one of two structures allowed by federal law:5Internal Revenue Service. Retirement Topics – Vesting
- Cliff vesting: 0% ownership until three years of service, then a jump to 100% all at once.
- Graded vesting: ownership builds year by year, commonly 0% after year one, 20% after year two, 40% after year three, and so on until 100% at year six.
Some employers offer immediate vesting on everything to help attract and keep talent, but the schedules above are the slowest a plan can legally impose. When an employee leaves before becoming fully vested, the unvested portion is forfeited back to the plan and can either reduce future employer contributions or be reallocated among remaining participants, depending on what the plan document says.
Getting Money Out
The tax breaks come with restrictions on access. Reaching age 59½, leaving the job, becoming permanently disabled, or plan termination all open the door to penalty-free distributions. Take money out before 59½ without a qualifying exception and you owe ordinary income tax on the distribution plus a 10% additional tax.6Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
The money can’t stay in the plan forever, either. Required minimum distributions kick in at age 73 for participants born before 1960 and at 75 for participants born in 1960 or later.7Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs Missing an RMD triggers a 25% excise tax on the shortfall, dropping to 10% if you correct the mistake within two years.
Loans
If the plan document allows loans, a participant can borrow the lesser of 50% of the vested balance or $50,000. A plan can also allow up to $10,000 when 50% of the balance is below that figure, though not every plan includes the provision.8Internal Revenue Service. Retirement Topics – Loans Repayments, with interest, go back into your own account. The main risk: leaving the job before the loan is repaid usually means the outstanding balance is treated as a taxable distribution, and the 10% penalty can apply on top of income tax.
Hardship Withdrawals
Some plans allow hardship withdrawals for an immediate and heavy financial need. The IRS recognizes six safe harbor reasons that automatically qualify, covering medical costs, purchase of a primary home, tuition and post-secondary education expenses for the next 12 months, prevention of eviction or foreclosure on a primary residence, funeral expenses, and repairs to a primary residence.9Internal Revenue Service. Retirement Topics – Hardship Distributions Hardship money is still taxable, still subject to the 10% penalty if the participant is under 59½, and unlike a loan, it isn’t repaid. Once it leaves the account, it’s gone.
What the Employer Is on the Hook For
Running the plan isn’t just paperwork. Anyone who exercises control over the plan’s management, assets, or administration is an ERISA fiduciary and carries personal liability for how the plan is run. The Department of Labor identifies four core duties:10U.S. Department of Labor. Fiduciary Responsibilities
- Acting solely in the interest of participants and their beneficiaries.
- Exercising the care and diligence a knowledgeable person would use in the same situation.
- Diversifying the plan’s investments to minimize the risk of large losses.
- Following the terms of the written plan document, so long as those terms are consistent with ERISA.
A fiduciary who breaches these duties can be held personally liable to restore any losses the plan suffered, and courts can remove a fiduciary from the role. Many small employers stumble here by setting up a plan and never revisiting it. Failing to monitor investment fees, or leaving the plan document unchanged after a law change, is itself a breach.
Form 5500
Every 401(k) plan files an annual return with the IRS and DOL, using the form that matches its size:11Internal Revenue Service. Form 5500 Corner
- Form 5500-EZ for one-participant plans (the owner, and possibly a spouse).
- Form 5500-SF for small plans with fewer than 100 participants.
- Form 5500 for plans with 100 or more participants.
The return is due on the last day of the seventh month after the plan year ends, which is July 31 for a calendar-year plan. Late filings can bring significant per-day DOL penalties.
Fidelity Bond
ERISA requires plans with more than one participant to maintain a fidelity bond covering anyone who handles plan funds. The bond has to equal at least 10% of the plan’s trust assets, subject to a $1,000 minimum and a $500,000 maximum.12Internal Revenue Service. Defined Contribution Plans With Less Than $250,000 in Assets The employer should recheck the amount each year as the plan grows.
Ending the Plan
An employer can terminate a 401(k) profit sharing plan at any time, but the IRS requires a specific sequence: amend the plan to set a termination date and stop future contributions, vest every participant at 100%, notify participants about the termination and their rollover options, distribute all plan assets as soon as administratively feasible (generally within 12 months), and file a final Form 5500.13Internal Revenue Service. Terminating a Retirement Plan
The mandatory full-vesting step is the one that catches employers off guard. Even employees who would have been 0% vested under the normal schedule become fully vested at termination. If a lot of unvested money is sitting in the plan, shutting it down costs more than expected. Model the accelerated vesting before making the decision.