Profit-sharing plans, employee stock ownership plans, and 401(k) plans are some popular

A profit-sharing plan is a retirement plan that gives employees a share in the profits of a company. Under this type of plan, also known as a deferred profit-sharing plan (DPSP), an employee receives a percentage of a company’s profits based on its quarterly or annual earnings. This is a great way for a business to give its employees a sense of ownership in the company, but there are typically restrictions as to when and how a person can withdraw these funds without penalties.

• A profit-sharing plan gives employees a share in their company’s profits based on its quarterly or annual earnings.
• It is up to the company to decide how much of its profits it wishes to share.
• Contributions to a profit-sharing plan are made by the company only; employees cannot make them, too.

So how does profit sharing work? Well, to start, a profit-sharing plan is any retirement plan that accepts discretionary employer contributions. This means a retirement plan with employee contributions, such as a 401(k) or something similar, is not a profit-sharing plan, because of the personal contributions.

Because employers set up profit-sharing plans, businesses decide how much they want to allocate to each employee. A company that offers a profit-sharing plan adjusts it as needed, sometimes making zero contributions in some years. In the years when it makes contributions, however, the company must come up with a set formula for profit allocation.

The most common way for a business to determine the allocation of a profit-sharing plan is through the comp-to-comp method. Using this calculation, an employer first calculates the sum total of all of its employees’ compensation. Then, to determine what percentage of the profit-sharing plan, an employee is entitled to, the company divides each employee’s annual compensation by that total. To arrive at the amount due to the employee, that percentage is multiplied by the amount of total profits being shared.

The most frequently used formula for a company to determine a profit-sharing allocation is called the “comp-to-comp method.”

Let’s assume a business with only two employees uses a comp-to-comp method for profit sharing. In this case, employee A earns $50,000 a year, and employee B earns $100,000 a year. If the business owner shares 10% of the annual profits and the business earns $100,000 in a fiscal year, the company would allocate profit share as follows:

• Employee A = ($100,000 X 0.10) X ($50,000 / $150,000), or $3,333.33
• Employee B = ($100,000 X 0.10) X ($100,000 / $150,000), or $6,666.67

The contribution limit for a company sharing profits with an employee for 2022 and $67,500 including catch-up contributions for those 50 or over during the year.

A profit-sharing plan is available for a business of any size, and a company can establish one even if it already has other retirement plans. Further, a company has a lot of flexibility in how it can implement a profit-sharing plan. As with a 401(k) plan, an employer has full discretion over how and when it makes contributions. However, all companies have to prove that a profit-sharing plan does not discriminate in favor of highly compensated employees.

As of 2022, the contribution limit for a company sharing its profits may not exceed the lesser of 100% of your compensation or $61,000. This limit increases to $67,500 for 2022 if you include catch-up contributions. In addition, the amount of an employee’s salary that can be considered for a profit-sharing plan is limited, in 2022 to $305,000.

To implement a profit-sharing plan, all businesses must fill out an Internal Revenue Service Form 5500 and disclose all participants of the plan. Early withdrawals, just as with other retirement plans, are subject to penalties, though with certain exceptions.

An employee stock ownership plan, or ESOP, is a benefit plan that gives a company’s workers an ownership stake in the business through the company’s stock. Employees can achieve ownership in a variety of ways, through purchasing the company’s shares directly or being given stock by the company.

For employees, ESOPs provide a way to put money away for retirement outside of traditional stocks and bonds. ESOP plans allow employees to invest directly into the company they work for, and then realize potential gains on the company stock after turning 59 ½ years old. In some circumstances employees can realize their profits sooner, but for most ESOP participants, profits are cashed out during retirement.

Below is an overview of how these plans work and what they’re best used for.

ESOP accounts are a type of defined contribution plan that are primarily intended for retirement. The National Center for Employee Ownership (NCEO) estimates that there were nearly 6,500 ESOPs covering more than 14 million participants as of 2020.

In order to establish an ESOP, a company first sets up a trust fund into which it deposits either shares of the company or money to buy them. The company can also use the trust to borrow money to purchase stock and then later deposit money into the trust to repay the loan.

Shares in this trust are then distributed and allocated to employees of the company. Some plans allow employees to invest in company stock through their 401(k) plan, or the ESOP may match the employee’s 401(k) contribution with company shares.

Shares that are given to the employee may be held in a trust on the employee’s behalf until the employee resigns or retires. The distribution of shares may also be tied to a vesting schedule, much like an employer match on a 401(k) can have. Each company has its own vesting requirements, and once an employee is fully vested, they will have full ownership rights of their shares.

Vesting can happen immediately (immediate vesting), after a certain period (cliff vesting) or little by little over a number of years (gradual vesting.)

When can employees access their ESOP shares?

ESOPs are considered defined contribution plans, and as such, come with certain rules as to when shareholders will have full access to their money.

The amount an employee will receive is tied to the value of the shares they were allocated and how many they have received. The full number of shares will be available only once they have become fully vested, according to their company’s vesting schedule.

When a worker’s employment ends, the company can make an ESOP distribution in the form of shares, cash or a combination of both. Typically, the ESOP plan repurchases the shares from the employee and the employee receives the cash value of the shares.

Usually, the fair market value of the shares is determined each year during an annual valuation. All shareholders are notified of the price, and this is what they can expect to receive if their shares are liquidated.

Payments are made either in a lump sum or over the course of (typically) five years. Longer-term payments are distributed in equal installments.

How long before I get my ESOP money?

Employers must begin distributions after a specified time, made clear in the plan agreement signed by the employee, although there are exceptions.

An important thing to remember is that ESOPs are qualified retirement plans and are subject to a 10 percent penalty if you touch the money before 59 ½ years of age. However, dividends passed through the ESOP are not subject to this penalty tax.

Employees who reach the plan’s normal retirement age (which usually cannot be later than 65, in an ESOP’s case), become disabled or pass away must receive their first payment from an ESOP plan during the next plan year.

Another exception is employees who quit or are fired must begin to receive distributions no later than six years after the year in which they left the organization.

Many times plans will allow those who have been terminated to begin distributions at age 55, and they can do so without the penalty tax. In rare circumstances, ESOPs will allow employees to borrow against their plan, as 401(k)s sometimes allow.

Mutual tax benefits

ESOP plans have tax benefits that are beneficial both to the company issuing them and the employees receiving the shares.

Company contributions into the ESOP trust fund are tax-deductible for the company. If stock is deposited into the trust, the company can generally deduct the fair market value of the shares from its taxable income.  Companies can also deposit tax-deductible cash into the ESOP trust, using it at a later date to purchase shares on their employees’ behalf.

For employees, they pay no tax on the contributions they make into the account. Employees pay taxes only during the distribution of the account, and even then, can enjoy favorable tax treatment. The distributions from an ESOP can be rolled over into an IRA or other tax-advantaged retirement account, and any gains over time may be taxed as capital gains instead of income, potentially saving significant money.

ESOPs vs. profit-sharing plans

How do ESOPs compare to profit-sharing plans, another popular benefit? The two plans share many similarities, and a profit-sharing plan is still technically an employee benefit plan, but there are some key differences.

Profit-sharing plans are incentivized plans like an ESOP, but in a profit-sharing plan employees are given a share of the company’s profits. The company decides what percentage of profits to provide, if there are any to be paid out in that particular year at all.

Profit-sharing plans also allow companies to invest pre-tax dollars into a trust for employees, and have tax benefits for workers as well. Payments from profit-sharing plans are not subject to Medicare or Social Security tax, netting the employee more benefit in the end. Profit-sharing plans are also considered defined contribution plans for retirement, and operate under the same penalty rules as ESOPs and similar retirement accounts.

Profit-sharing contributions are typically made in cash, and then put into investments besides company shares. In contrast, ESOP plans invest back into the company and into something employees are already astutely aware of – their own day-to-day work.

Benefits of an ESOP plan

ESOPs can create sound financial footing for employees. Businesses with ESOPs provided greater financial security for employees heading into and then during the pandemic, including higher job retention, compared to comparable firms without ESOPs in place, according to a 2021 survey by the NCEO.

ESOP plans have positive effects on employee retention and overall employee financial wellness. The NCEO study found that companies with ESOP plans retained or added on average 6 additional employees from 2019-2020 compared to non-ESOP employers.

Companies also contribute more to ESOP plans than 401(k) matches. The same NCEO study found that the average annual employer contribution to an S ESOP (an ESOP owned by an S corporation) plan was 2.6 times more than that of companies only offering a 401(k). About 94 percent of total contributions to ESOPs also came from the issuing company, compared to just 31 percent for 401(k) plans.

Participation in ESOP plans also comes with the potential for larger payouts. The NCEO states that employees’ ESOP account balances hold an estimated $67,000 more in retirement assets than employees at the average business.

ESOPs also often provide a market for shares held by departing members of a company, such as an owner or majority partner. About two-thirds of ESOPs are created for this reason, says the NCEO.

Bottom line

If you have the ability to participate in an ESOP plan, it’s a good idea to take advantage of the opportunity. ESOPs allow employees to have an ownership stake in the company they work for every day, incentivize employees to do what’s best for shareholders overall (since they are one), and provide for enhanced financial stability. While they come with the limitations of most defined contribution plans, ESOPs can be a great addition to retirement savings.