What is a Profit Sharing Plan?
A profit-sharing plan is a defined contribution pension plan in which the workers and employees are given an opportunity to obtain their share in the overall profit of the organization in such a way that they are encouraged to contribute more and more to the profit of the organization and motivates to give their best efforts, thus it is an incentive plan that gives a variable benefit to the employees based on a certain percentage of profit.
This plan is a type of plan that gives a win-win situation to both the employees as well as the employer. It encourages the employees to give their best efforts in the organization which in turn would generate more profits and increase the wealth of the organization. Thus both the party are benefited from increased earnings.
How Does it Work?
This plan specifies a certain percentage of profits for every particular employee covered under the plan. Thus it is upon the company to decide how much profit will be shared with employees covered under a profit-sharing plan. Also, it is important to note here that only employers, company or the organization can contribute to this plan and not the employees.
This plan provided quarterly or annual incentives to the employees of the organization based upon the quarterly and annual returns respectively. Further, employees can get their share in the profit of the organization either in the form of cash or the stock of the company wherein the contribution is provided to a qualified tax-deferred retirement account that allows a penalty-free distribution to the employees at a certain Pre defined age group.
Further, there are also schemes where the employee decides to leave the organization and join another one, then, in that case, the existing contribution is rolled over to another employer’s plan subject to a certain percentage of penalty on the existing contribution.
Types of Profit-Sharing Plans
#1 – Cash Plan
The employees covered under this plan are given with cash or stock of the organization or company at the end of every year or quarter as the case may be. Thus they are given instant results of their efforts in the organization. The main disadvantage of this type of plan is that the employees are taxed on this additional income as a regular income
#2 – Deferred Plans
The profit-sharing is directed into a specific fund know as the trust fund which provides the rewards to the employees on a later date often on the retirement of the employees. Accordingly, immediate taxation on the incomes of the employees is avoided under a deferred plan. Further, the qualified investment plan provides employees a variety of choices in their investment. Also, the retirement pay is increased as and when the contribution is increased.
#3 – Combination Plan
This plan, as the name suggests is a combination of both the above-mentioned plans which pars a part of the contribution in cash periodically, and part of the contribution is deferred into a trust fund to be paid at the time of retirement
Example of Profit-Sharing Plans
Suppose a company ABC corporation earns an annual profit if $500,000. This company employs 3 employees, X, Y, Z. Now, all the employees earns income of $400,000, $200,000 and $400,000 respectively. The company has a policy of a 10%profit sharing plan.
Hence the profit of $50,000 ( being 10% of 500,000 ) is shared among the employees as under:
- A: $20,000 (50,000×400,000/1,000,000)
- B: $10,000 (50,000×200,000/1,000,000)
- C: $20,000 (50,000×400,000/1,000,000)
Rules of a Profit-Sharing Plan
A profit-sharing plan is a way used to best the interest of the employees of the organization. The simple rule of this plan is that the more the company earns profit, the more the employees of the organization earns as a reward. Thus there is a direct relationship between the efforts the employees put in the organization and the profit-sharing incentives they receive from the organization. Thus this plan helps to achieve a win-win situation in the organization for the employees as well as the company.
Difference between 401(k) Plan and Profit-Sharing Plan
A very important difference between a 401(k) plan and a profit-sharing plan lies in those who contribute to the plan of the employee. Under the former plan, the employee itself contributes to the plan for the investment in the retirement plan while in the later, the retirement payments only compromise the contribution from the employer in contrast to the former.
- It encourages both the employee to put in more and more effort into the organization and increase the profitability of the organization.
- With more efforts, come more profits. Thus the organization is benefitted even after paying additional incentives to the employees.
- This incentive plan includes a type where payment is deferred and payee at the time of retirement. Thus the way of saving habits in the company culture is also increased.
- The focus of the employee is shifted from the quality of work to more and more profits.
- This way a false culture is motivated in the organization to ignore the qualitative aspect and only to focus on the quantitative aspect of the organization.
- This kind of culture is very disadvantageous in a long time from even though it provides satisfactory results in the short term.
- Salary of an individual goes up equally instead of based promotions, performance or merits. This way some category of employees might not feel motivated to work and put on more efforts in the organization.
As discussed above, a profit-sharing plan is more and more considered in today’s world since it provides a win-win situation to the entire company. Thus this plan helps an organization to grow and achieve heights.
This has been a guide to what is the Profit Sharing Plan and its definition. Here we discuss three types of Profit-Sharing plans (Cash, Deferred, and Combination) along with their example and rules. You may learn more about Financing from the following articles –