In a profit-sharing plan, companies contribute a percentage of their pre-tax profits into a pool and award it to eligible employees. These amounts are distributed based on an employer’s salary or level with the company. This can also be used as a bonus to existing benefit plans.
A profit-sharing plan differs from a 401(k) plan because the former plan allows employers to make contributions instead of employees. Instead of a set amount, companies contribute an amount based on their discretion.
How Does Profit-Sharing Plan Work?
When a pool has been created, the company then makes a formula for distribution. In accordance with the Department of Labor, the following steps are necessary for setting up a profit-sharing plan:
- Make a written plan document
- Create a record-keeping system
- Set up a trust for the plan’s assets
- Provide eligible employees with plan information to participate
Companies have to maintain detailed records of how the plan has to be distributed among employees. The plans can also be updated, but it has to be done with good oversight.
Profits are shared in the form of bonds, stocks or cash.
Benefits of Profit-Sharing Plan
Employers benefit from profit-sharing based on employee motivation. In other words, it helps companies retain their most talented and capable employees, which is also a motivating factor that enhances loyalty and productivity. And since there needs to be a profit before distribution, this plan is less risky than outright bonuses.
Profit sharing increases the feeling of ownership employees have for their jobs because they are the ones who created the profits for their company. Another benefit is that costs rise and fall with revenue as well.
Disadvantages of Profit-Sharing
Some of the worst things that profit-sharing could potentially bring out are bad behavior within employees who prefer profitability over quality. Since there is no difference between merit or performance, those employees who contributed less will still receive their share in the profits.
It is due to the pros and cons of profit-sharing that companies and HR teams have to conduct a cost-benefit analysis before they decide to go ahead with this plan.