LAST REVIEWED May 02 2020 9 MIN READ
By The Human Interest Team
A profit-sharing plan offers a variety of benefits for both employers and employees. Employers opt for this type of retirement plan partly because it enables them to decide how much they want to contribute to their employees’ retirement. As for employees, profit sharing is a great way to save for retirement, especially if they work for a highly profitable company. If your employer has a profit-sharing plan, it’s essential to know how it works, so that you’ll have better control over your retirement planning.
What Is a Profit-Sharing Plan?
A profit-sharing plan refers to a retirement plan that requires employers to give their employees a certain percentage of their annual profits. In 2020, the maximum contribution limit for profit-sharing is $57,000 or 25% of compensation, whichever is less. Employers set up profit-sharing plans to help their employees save for retirement. These plans are similar to 401(k) plans because they’re tax-deferred retirement plans and regarded as defined-contribution plans. Like other retirement plans, cashing out a profit-sharing plan will make your funds subject to tax. The tax rate that applies may vary from 10% to 37%, depending on your tax bracket.
How to Withdraw from a Profit-Sharing Plan
There are certain rules you have to follow when cashing out a profit-sharing plan. If you decide to make an early withdrawal, you’re required to pay tax on the amount you withdraw and a penalty. In a 401(k) profit-sharing plan, you’re allowed to contribute pre-tax compensation to your account. However, you must include the funds you withdraw from your profit-sharing plan in your taxable income.
Similar to a 401(k), a profit-sharing plan enables you to save for retirement on a tax-deferred basis. The funds that go into your profit-sharing plan won’t incur any tax as they increase through underlying investments. You’ll only have to pay income tax when cashing out your profit-sharing plan. The following are the proper steps for early and regular withdrawals.
Step 1 – Find out about your employer’s withdrawal policy. Profit-sharing plans are more flexible than Individual Retirement Account (IRA) or 401(k) plans. Some plans allow employees who have been participants for a certain number of years to withdraw a portion of their funds early. In many cases, cashing out a profit-sharing plan early is permissible for employees who are coping with unexpected expenses such as high medical bills or other forms of financial hardship.
Step 2 – Calculate the amount of tax you need to pay. Even if your profit-sharing plan allows you to make early withdrawals, you’ll still have to pay tax and a 10% penalty tax on the amount you withdraw if you haven’t reached 59 1/2 years old. The penalty varies based on your tax bracket
Step 3 – Look for any penalty tax exemptions. For instance, if you retire from your job after the age of 55, the Internal Revenue Service (IRS) doesn’t require you to pay a penalty for withdrawals. Additionally, the IRS exempts funds rolled over to another employer plan and distributions that result from property division during a divorce, if it’s conducted under a qualified domestic relations order.
Step 4 – Complete the required paperwork and submit it to your employer.
Step 1 – Find out from your employer when you can start withdrawing funds after you turn 59 1/2. After the age of 59 1/2, you won’t have to pay a penalty when cashing out your profit-sharing plan. However, some employers may require you to wait longer. For example, participants of the Iron Workers’ plan can only make regular withdrawals after they turn 65 unless they’re eligible for an exception.
Step 2 – Calculate your tax payments. Although you aren’t required to pay penalty taxes after you reach 59 1/2 years old, you still have to pay federal income tax on the funds you withdraw from your profit-sharing plan. After you turn 70 1/2, you must start making minimum withdrawals, but you can also opt to withdraw all your money at once. Decide which option works best for you.
Step 3 – Start cashing out your profit-sharing plan when your employer allows or at the point when you’ll get the greatest benefit. If you decide to work beyond the age of 59 1/2 and postpone withdrawals until you retire, your withdrawals may be subject to a more favorable tax rate because you’ll probably have a lower income.
Tax Rates on Profit-Sharing Distributions
If you’re participating in a 401(k) profit-sharing plan, you can contribute pretax earnings to your account. When you withdraw money from your account, you have to include the amount in your taxable income. If you haven’t reached the age of 55, you’re also required to pay a 10% penalty tax on an early withdrawal, unless you’re eligible for an exception such as financial hardship or disability. To the IRS, profit-sharing distributions are regarded as ordinary income.
The tax rate that applies to your ordinary income is your marginal rate, meaning the tax on the “last dollar” of your annual income. Depending on your taxable income, you’ll belong to one of the following seven federal tax brackets for the 2019 tax year if you’re a married person filing jointly with your spouse:
10% for taxable income up to $19,400
12% for taxable income from $19,401 to $78,950
22% for taxable income from $78,951 to $168,400
24% for taxable income from $168,401 to $321,450
32% for taxable income from $321,451 to $408,200
35% for taxable income from $408,201 to $612,350
37% for taxable income from $612,351 or more
How to Shield Your Profit-Sharing Money From Taxes
If you want to shield your profit-sharing distributions from current taxes, you can roll them into a traditional IRA or another employer plan. You may also be able to opt for a trustee-to-trustee transfer, which is a simpler way to rollover funds.
If you’re receiving cash from your profit-sharing account, you can avoid taxes by depositing it into a traditional IRA or another employer plan within 60 days. If you make the deposit after the deadline, the IRS will tax the funds and may penalize you for early withdrawal if you haven’t reached the age of 55. Your employer will withhold 20% of the amount you withdraw unless you make a trustee-to-trustee transfer.
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