How Is Profit Sharing Taxed?

Profit-sharing plan refers to a type of employer-funded retirement plan. Each year, employers can elect to make a discretionary contribution to the plan on behalf of their employees. Employers make contributions from company profits.

Contributions

Contributions made by your employer to a profit-sharing plan are tax-deferred. When your employer makes a contribution on your behalf, you do not owe any tax at that time. You will pay the tax in the future when you make a withdrawal from the plan.

Earnings

Like contributions, investment earnings within a profit-sharing plan are tax-deferred. You will not pay any tax on the earnings until you make a withdrawal from the plan.

Distributions

Distributions from a profit-sharing plan are taxable income and must be reported on an individual's tax return. Distributions are taxed at a taxpayer's ordinary income rate. Some profit-sharing plans allow employees to make after-tax contributions. In this case, a portion of the distributions would be tax-free. The IRS uses a special formula to determine what portion of a monthly retirement benefit would be attributed to after-tax contributions.

Possible Penalties

Depending on your employer's plan, a 10% penalty may apply to distributions made before ate 59 1/2, unless a hardship exception applies. Profit-sharing plans can allow withdrawals as early as age 55 with five years of service. If this is the case, no penalty would apply if the retiree met those requirements.

References

• AXA-Equitable: How do Profit-Sharing Plans Work?
• Wells Fargo Small Business: Profit-Sharing Plans and Money Purchase Plans
• Bank Rate: Taxes on Profit-Sharing Distributions

Resources

• Department of Labor: What You Should Know About Your Retirement Plan
• IRS: Pension and Annuity Income