Updated July 17, 2023
Definition of Profit Sharing Plan
A profit-sharing plan is a kind of retirement benefit plan in which employees get a specific percentage share in the company’s quarterly or annual profit after their retirement. This is a way to make employees feel that they belong to the company they are working in which further helps in creating a sense of ownership.
There are certain restrictions on these kinds of plans as to when and how the employee will be able to withdraw the fund which is contributed by the employers.
Explanation
Profit-sharing plans allow discretionary contributions from the employers; employees do not contribute to profit-sharing plans. The plans are set up by the employers, thus, contributions are also decided by the employer only. They can contribute according to some set formula in the years they have decided to contribute. In some years, employers may decide not to contribute at all.
The company decides how much it is going to contribute to each employee. Generally, it is done with the help of the comp-to-comp method. As per the method, first of all, the entire sum total of all the employee’s contributions is calculated and then to decide the percentage of each employee their annual compensation is divided by the total compensation. The percentage is applied to the total profit decided to be shared by the employers.
How Does it Work?
Profit-sharing plans give employees a chance to get a percentage of the profit earned by the organization on a quarterly or annual basis in the form of retirement benefits. How it works can be understood from the below points:
- The profit-sharing plan is set up by the employer or company.
- The profit that is to be shared by employers with the employees is also set up by the employee.
- The contribution in terms of profit is also done by the employers, which is adjusted as needed i.e. employers can even decide for zero contribution in some years.
- The employees are not allowed to contribute to the profit-sharing plan.
- The calculation of the percentage share of the employee is done according to the comp-to-comp method.
- The employees geta share of profit in the form of retirement benefits after their retirement.
Example of Profit Sharing Plan
Let us take an example of an employee who is earning $90,000 in a year. The employee shares 8% of the profit annually as the part ofthe profit-sharing plan. Let us assume that the profit for the current year is $120,000. Now the allocation of profit to the employee will be done in the following way.
$90,000×8% * ($90,000 / $120,000) = $5,400.
Types of Profit Sharing Plan
Mainly there are three types of profit-sharing plans as below:
- Deferred profit-sharing plan: In this type of plan, the employee gets benefits at a certain period of time like at the time of retirement, death benefit, disability, or when they leave the company. These funds are invested in the pension fund and are given after retirement. The contribution is not taxable until it is received in the form of retirement benefit.
- Cash profit-sharing plan: In this type of plan, the company shares its profit in the form of the cash-bonus at the end of each year. The bonus is a taxable part of the employees’ income.
- Combination plan:This plan is a combination of the above two plans, wherein employees get the share of profit as a retirement benefit and also awarded a cash bonus every year.
How to Set Up a Profit Sharing Plan?
The businesses should follow below steps to set up the profit-sharing plan in the company:
- They should formulate a written plan document very much like the official plan document for 401 K plans.
- They should set up a trust for the plan assets.
- They should ensure proper records or bookkeeping so that no transaction or in and out of funds are left out.
- The plan should be explained to the employees who are eligible to participate.
- Lastly, companies can administer these plans themselves or can hire third-party administrators.
Advantages
Some of the advantages are given below:
- It creates a sense of belongingness in the employees and brings them together to work towards the success of the company.
- As it is a kind of extra financial benefit, it increases the motivation level in the employees.
- Additional benefits allow the employee to live comfortably post-retirement which brings a sense of commitment in the employees towards the company.
- It helps in promoting the well-being of the employees.
Disadvantages
Some of the disadvantages are given below:
- Sometimes the cost involved in the profit-sharing plan is very high.
- Profit-sharing calculates the percentage share of the employees on the basis of their compensation thus, employees at a higher level get higher bonuses or benefits in comparison to employees at a lower level.
- In its criticism, it is also said that it changes the focus of the employees because they start working for bonuses and benefits instead of the company goals.
- As the funds are invested in several investment options to provide a retirement benefit to the employee, this fund may underperform as well. In other words,the employer cannot provide a guarantee over the amount of benefit.
Conclusion
Profit-sharing plans are set up by the employer to achieve many goals like increasing the sense of commitment in the employees, retaining the employees, creating high motivation environment and promoting the well-being of the employees. It does have some negative points as well, but the benefits overshadow them.
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