In an employee stock ownership plan (ESOP), employees buy stock in their company through payroll withholding or some other method, or the corporation contributes shares of its stock to funds that allocate the shares to employees based on their annual compensation.
Advantages. The advantage to employees is that they acquire stock of the company they work for at either no cost or reduced cost. Employees owe taxes on the value of the stock only when it is distributed to them. In the meantime, the stock can appreciate tax-free. And when employees take possession of the stock, they can continue the tax-favored treatment by rolling it over into an IRA.
Drawbacks. Because all or most of your stake is invested in one company, you lose the protection of a diversified investment portfolio. And because you are already counting on the company to provide you with your preretirement income, you should think twice about whether you want to depend on its stock price to provide your income in retirement as well.
Some profit-sharing plans pay the money directly to employees each year in the form of cash, meaning employees owe taxes on it, and it's up to them to decide how to invest it (or spend it).
Most plans, though, defer the payout until you leave the company, directing the money into an account that grows year by year.
You owe no tax until you withdraw the money, which is usually invested in the meantime by professional investment counselors under the supervision of the plan trustees or an investment committee. A small percentage of profit-sharing plans give employees a voice in the selection of investments.
Some plans invest part of their funds in the company's own stock. That can prove an advantage or disadvantage to the employee, depending on the company's dividend-payment policy (if the stock held by the plan earns dividends), and on whether the stock appreciates or declines in value as the years go by.
Although they lack the guarantees of regular pension plans, profit-sharing programs make it possible to accumulate sizable retirement funds when you work a long time for a successful company. Many plans are offered in combination with other retirement plans. The ideal arrangement would be a program that combined a defined-benefit pension plan with deferred profit sharing.