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.