Profit-sharing plans are created by employers and offered as incentive- based compensation. They are designed to award employees a percentage of a company’s profits. A portion of pre-tax profits is put into a pool to be distributed among eligible employees. Amounts distributed may be based on an employee’s salary, which will entitle higher-paid employees to a slightly higher amount of the pool profits.
Why Employers Start
A profit-sharing plan is a good incentive to help attract and keep talented employees. This type of plan has discretionary contributions; that is, employers can determine how much and when to contribute to the plan. A profit-sharing plan offers flexibility in designing key features. The contributed money and earnings are generally not taxed by federal or state government until they are distributed. A participant may be allowed to take his benefits with him if he leaves the company. Contributed money may grow through investments, such as stocks and mutual funds.
The participants of a profit-sharing plan include rank-and-file employees as well as owners and managers. Contributions are made to participants' accounts based on business profitability. Vesting can be designed so that employers' contributions become vested over time according to a vesting schedule. Annual testing is typically done to ensure that the amount of contributions does not discriminate in favor of owners and managers.
The benefits that are available for a participant are based upon the account balance of the participant at the time of distribution. Participants that are eligible to take a distribution can typically elect to take a lump-sum distribution, transfer their account directly to an IRA or another employer’s retirement plan, or take periodic distribution. A form 1099-R (Distribution from Pensions, Annuities, Retirement or Profit Sharing Plans, IRAs, Insurance Contracts) is sent to recipients and the IRS if distributions are received from the plan during the year.
Pros and Cons
Profit-sharing plans can bring various groups of employees together in efforts to promote the success of the company. Profit-sharing plans can help employees focus on profitability. They can enhance the commitment of employees to organizational goals. However, they focus only on the goal of profitability. They are not good for smaller companies because they can cause drastic swings in earnings.