Originally published on Kiplinger.com on October 11, 2023.
Employee Stock Ownership Plans (ESOPs) offer a unique opportunity for employees to participate in the growth and success of the companies they work for. These plans provide employees with a means of accumulating wealth and building a retirement nest egg.
What is an ESOP?
The ESOP is a tax-deferred retirement plan. Through your participation in the ESOP retirement plan, you have an ownership interest in shares of company stock that are credited to your ESOP account balance. These shares are provided each year at no cost to you. The account will grow if your company achieves good financial results. You will be taxed when you cash out the funds in your ESOP account.
As an employee owner, you are part of a team whose actions and decisions impact the company’s financial results and your retirement account balance. The culture of employee ownership is not only about increasing the value of the company, but relating to peers, customers, suppliers and other companies in your industry, as well as the community in which you work. The information provided below may be different from your company’s ESOP, be sure to check with your representative.
Company Contributions
Your ESOP retirement account is company-funded, not employee-contributed like a 401(k). Every year, the company’s board of directors decides whether and how much to contribute to the plan. Some ESOP companies aim for a steady benefit rate of 5% (or more) of eligible employee salary, while others vary year to year and may be less predictable. As an example, if your annual salary is $100,000 and the benefit level this year is 5%, your ESOP account balance would be credited with company stock shares worth $5,000.
Stock Value and Your Retirement Account
For ESOPs that are not publicly traded, the value of ESOP stock is usually determined once a year after the end of the company’s fiscal year. The ESOP trustee retains an independent valuation agent to determine the stock value. The valuation agent[1] reviews the company financial statements and business forecast of the company. If your company is affected by poor economic conditions or reduced customer demand, the value of company stock and your ESOP retirement account balance could fall. If customer demand increases and the company continues to be profitable, the value of company stock and your retirement account could rise.
Stock Value Statements and Distribution Windows
Once the stock value is determined, allocations of shares to your ESOP retirement account are completed. Most ESOP companies allocate shares and apply your vesting credits once a year. After your new balance is determined, you will receive an annual ESOP account statement.
Your statement will show the beginning and ending balance of shares, new contributions allocated to your account, the new share price and the vested percentage of your account.
As an example, let’s consider a 100% vested (more on vesting below) eligible participant with compensation of $102,000 and a 5% benefit level. At the beginning of the year, the employee’s account has 1,500 shares at $195 per share value, equaling $292,500 in ESOP value. Twenty-five new shares are credited to the employee’s ESOP account for the year, representing $5,125, or 5%, of the $102,000 annual salary. As of the end of the year, the employee has 1,525 shares times $205 per share equaling a new ESOP value of $312,625.
If you are eligible to make a retirement distribution election or diversification request, you will be notified shortly after you receive your statement.
How Vesting Works
Vesting refers to the percentage of your account you are entitled to when you leave the company or begin taking distributions from your ESOP account. By law, vesting follows one of two schedules.
Cliff vesting. No vesting in the first years of employment, followed by 100% vesting after not more than three years of service (usually 1,000 hours or more of work in a plan year).
Graded vesting. Twenty percent vesting after the second year of service, with 20% more each year until 100% vesting occurs after the sixth year of service.
Some companies have more generous vesting schedules than the ones outlined above.
If you reach normal retirement age (65), die or become permanently disabled, or your plan is terminated, you become 100% vested immediately. The unvested value of your account balance is forfeited if you leave the company before you are 100% vested. Consult your ESOP representative to confirm your vesting schedule.
Diversification
Diversification reduces concentration risk in a single company stock. ESOP participants are provided with an option beginning at age 55 with 10 years of plan participation to diversify 25% of cumulative vested company shares. Upon attaining age 60, participants may elect to diversify up to 50% of cumulative vested shares. Diversification is the process of selling shares in your ESOP account and reinvesting the proceeds, also known as a rollover, in another tax-deferred 401(k) or IRA investment account. The 401(k) or IRA may offer a choice of stock, bond, ETF and mutual fund investments. An alternative to a rollover is to cash the check. Spending the cash reduces your retirement savings and subjects the payment to income taxes and IRS penalties if they apply.
Diversification is the process of selling shares in your ESOP account and reinvesting the proceeds in another tax deferred 401k or IRA investment account.
Distributions When You Leave the Company
If you retire or terminate employment, you may be eligible to take distributions from your ESOP account vested balance. If the balance is $5,000 or less, it will often be paid in a lump sum. If your account balance is more than $5,000, it may be paid in a series of five substantially equal annual installments instead of a lump sum. If you depart prior to retirement age, you may need to wait to make a distribution election until the fifth anniversary of your termination date.
Specific amounts and rules may vary by company. Yours may have a more generous payment schedule and may not have a waiting period. Some companies allow employees to participate in share price gains or losses while being paid installments, others freeze your share price when you terminate employment or retire. Be sure to check with your ESOP representative or review your plan document.
If you die or become permanently disabled, you may be eligible for an accelerated distribution schedule.
Retirement distributions can be requested when you retire (typically age 65). Some companies allow retirement as early as age 55 with 30 years of service. Retirement installments are generally paid in a series of five substantially equal installments. You must begin taking from your ESOP account balance by the time you reach age 73. Your company’s retirement schedule may vary from the one above.
Form of Payment and Taxes
As part of your distribution request, you can designate the form of payment. If you make a direct rollover to another retirement plan (a 401(k) or IRA), you continue to invest for retirement savings and defer paying taxes. If you do not elect a rollover and receive the payment by check, you have 60 days to deposit the money into another qualified retirement account to defer paying taxes.
If instead of rolling the money to another retirement plan, you elect a direct payment, then you will be responsible for paying income taxes and an wearly-withdrawal penalty (if any applies under age 59½).
Take Action
The benefits and responsibility of being an employee-owner translate to taking responsibility for your own financial well-being. Below are steps you can take:
Keep track of your ESOP and other retirement account balances.
Check your financial plan to ensure you are on pace to meet your retirement goals.
Consider the pros and cons of diversifying your company stock when eligible.
Understand the tax implications of your choices.
Forecast your retirement expenses and income.
Our next article in this series will cover important facts employee owners should be aware of, including; how much your company contributes to your ESOP account and 401(k), how your company stock is performing, and when you are eligible to spend your ESOP cash.
Final Thought
Are you comfortable with your progress toward retirement? Are you confident you’ll know how to handle your ESOP diversification and distribution when the time comes? Do you need help forecasting how your ESOP and 401(k) can generate retirement income? A wealth manager from the Peak Wealth Planning team can assist.
About this Series
This is part two of a six-part series in which Peter Newman, CFA, of Peak Wealth Planning, explains the benefits of employee ownership for the U.S. workforce. There are more than 6,500 Employee Stock Ownership Plans, or ESOPs, in the U.S. covering almost 14 million employees. Part one is Five Key Advantages to Working at an Employee-Owned Company Part three, Five Things Employee-Owners Need to Know About Their ESOP, will arrive in November.
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About the Author
Peter Newman is a Chartered Financial Advisor (CFA) and president of Peak Wealth Planning. He works with individuals nationwide that have accumulated wealth through company stock, ESOP shares, real estate, or running a business. Peter applies his unique background to help clients achieve their specific goals and enjoy peace of mind.
Peak Wealth Planning offers personalized concierge services to meet your wealth management needs, including financial planning, investment management, ESOP diversification, retirement income, insurance, and estate planning. As a fee-based financial advisor based in Chicago, Peak Wealth Planning serves a select group of clients in Illinois and across other states.