What is a Profit Sharing Plan?

This type of plan gives a win-win situation for both the employees and 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 parties 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, the company must decide how much profit will be shared with employees covered under a profit-sharing plan. Also, it is important to note that only employers, companies, or organizations can contribute to this plan, not the employees.

This plan provided quarterly or annual incentives to the employees of the organization based upon the quarterly and annual returnsAnnual ReturnsThe annual return is the income generated on an investment during a year as a percentage of the capital invested and is calculated using the geometric average. This return provides details about the compounded return earned yearly and compares the returns supplied by various investments like stocks, bonds, derivatives, mutual funds, etc.read more, respectively. Further, employees can get their share in the organization’s profit either in the form of cash or the company’s stock, 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.

You are free to use this image on you website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be HyperlinkedFor eg:Source: Profit Sharing Plan (wallstreetmojo.com)

Types of Profit-Sharing Plans

#1 – Cash Plan

The employees covered under this plan are given 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 known as the trust fund, which provides the rewards to the employees at a later date, often on the employees’ retirement. Accordingly, immediate taxation on the employees’ incomes is avoided under a deferred plan. Further, the qualified investment plan provides employees with various investment choices. Also, the retirement pay increases as and when the contribution increases.

#3 – Combination Plan

As the name suggests, this plan is a combination of both the plans mentioned above, which pays 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 of $500,000. This company employs three employees, X, Y, and Z. Now, all the employees earn an income of $400,000, $200,000, and $400,000, respectively. The company has a policy of a 10%profit sharing plan.

Solution:

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 to best the interest of the organization’s employees. The simple rule of this plan is that the more the company earns profit, the more the organization’s employees earn as a reward. Thus there is a direct relationship between the efforts the employees put into the organization and the profit-sharing incentives they receive. Thus this plan helps to achieve a win-win situation in the organization for the employees and 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 employee’s plan. Under the former plan, the employee itself contributes to the plan for the investment in the retirement plan, while in the latter, the retirement payments only compromise the contribution from the employer in contrast to the former.

Advantages

  • It encourages the employee to put more and more effort into the organization and increase the profitability of the organization.With more effort come more profits. Thus the organization benefitted even after paying additional incentives to the employees.This incentive plan includes a type where payment is deferred and payeePayeeA payee refers to a person, business, government, or any other entity that receives payment for providing goods or services.read more at the time of retirement. Thus the way of saving habits in the company culture is also increased.

Disadvantages

  • The employee’s focus 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 focus on the quantitative aspect of the organization.This kind of culture is very disadvantageous in the long time even though it provides satisfactory results in the short term.An individual’s salary goes up equally instead of based on promotions, performance, or merits. This way, some employees might not feel motivated to work and put more effort into the organization.

Conclusion

As discussed above, a profit-sharing plan is increasingly considered in today’s world since it provides a win-win situation for the entire company. Thus this plan helps an organization to grow and achieve heights.

This has been a guide to 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 –

  • Defined Contribution PlanAnnuity vs PensionCompare – IRA vs 401k401k vs Roth IRAPrivate Equity ETF