Tax Issues for the Employer: The company gets a deduction for the share of its profits which are contributed to the profit-sharing trust.
Tax Issues for the Employee: The employee pays no tax on the amount contributed to his account at this time, regardless of whether his interest is forfeitable or nonforfeitable. The full untaxed amount is invested by the trustee. These contributions may be pooled, or may allow employees to direct the contributions made on their behalf. Taxes for the employee enter the picture when withdrawals are made.
Some plans allow you to withdraw part of your share of the funds while you are still employed, for reasons such as hardships. This is taxed as ordinary income, and incurs a 10 percent penalty tax if withdrawn prior to age 59 1/2, unless you have contributed after-tax dollars to the funds. In that case, if the withdrawals do not exceed your contribution, there is no tax.
If your employment ends and the profit-sharing fund (plus any other qualified plans your employer has in place, such as a 401(k), a defined benefit pension plan) is paid out to you within one taxable year, here is the way the “lump sum distribution” you receive will be treated (but it must include full distributions from all the employer’s qualified plans):
o Your own after-tax contributions come back to you tax-free.
o If you reached age 50 before 1986 (born pre-1936), the taxable portion attributable to your participation in the plan before 1974 can be taxed, at your option, at a flat 20 percent rate or with the benefit of a ten-year income averaging rule under 1986 rates.
o The taxable portion attributable to post-1975 participation is subject to the above averaging rules if you were a participant for at least five years.
o If you received stock of your corporation as part of the distribution, the unrealized appreciation on that stock is not included in the taxable amount. It is not taxed until you sell the stock.
o Until December 31, 1999, if you had not attained age 50 prior to 1986, favorable lump sum treatment was limited to a one-time election of five-year averaging after you have reached age 59 1/2. After 1999, this option was no longer available.
o If none of the above apply to you, then the entire lump sum distribution would be included in your taxable income for the year in which you receive it. Such a spike in your taxable income could push your adjusted gross income so high that you would be in a higher tax bracket. This could cause you to be phased out of personal exemptions and itemized deductions.
o Better yet-if you were born after 1935-consider rolling over your lump sum into an IRA. It is possible to defer taxes on a lump sum distribution if, as you retire or depart, you transfer the distribution (less your own contribution) into an Individual Retirement Account. Until you draw out money from the IRA, earnings within your fund will accumulate tax-free. You can begin drawing from your IRA at age 59 1/2, or take earlier distributions prior to 59 1/2 that are part of a series of substantially equal periodic payments made at least annually for your life or a joint life expectancy or joint lives of yourself and a designated beneficiary. You could also wait until age 70 1/2, at which point some form of annuitized payments could be elected. Funds drawn from IRAs are taxed to the recipient. Premature withdrawals prior to age 53 1/2 that do not meet the above conditions (except for death or disability) result in a nondeductible 10 percent penalty tax on top of ordinary income tax and possible 20 percent tax withholding.
