This article was originally published on Kiplinger on October 16, 2024.
This is part five 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. See below for the links to the previous articles in the series.
Building upon the foundational understanding provided in the earlier articles of this series, we now shift our focus to a pivotal question faced by Employee Stock Ownership Plan (ESOP) participants: Should you opt for the diversification option?
In this article, we delve into the pros and cons of rolling over your diversification vs spending those funds straight away.
In a typical scenario, diversification means the ability to sell shares back to the company during your employment years, while distribution refers to selling back shares post separation from the company or upon retirement. We're here to help you navigate these considerations to make an informed decision for your ESOP participation.
About the Diversification Option
Even if your company is doing well and the share value is increasing, participants may prefer to diversify their investments to reduce concentration in a single company. This is the process of selling shares in your ESOP account and reinvesting the proceeds in a separate investment account.
Five Reasons To Diversify Your Company Stock
If you are planning to retire before medicare age 65, you may need funds to pay out of pocket for health insurance.
By spending from an IRA rollover account or 401(k) during early years of retirement, you could delay social security until age 70 to receive a 24% higher benefit.
If your stock has done well and makes up a significant portion of your net worth, you can ‘take some chips off the table’ and diversify your retirement investments.
If your employee owned company is in a cyclical industry and the stock valuations have been high, this might be a good time to reduce exposure.
Your financial plan shows you have sufficient investments to meet your retirement income needs, so it’s not necessary to continue taking concentrated stock risk.
Remember that concentrated risk builds wealth and diversification of your investments preserves wealth. Even if your ESOP account is doing really well, consider whether to diversify carefully. Individual company stocks can fluctuate up or down much more than a broad portfolio of thousands of stocks and bonds.
Concentrated risk builds wealth. Diversification preserves wealth.
Three Reasons Not To Diversify Your Company Stock
You or your spouse have significant 401(k), IRA or other investments making the ESOP less than 20% of your retirement nest egg.
The company stock is outperforming the broader US stock market. You believe this will continue and are comfortable with concentrated risk.
You plan on working until age 65 or 67 and will not need the proceeds from diversification to bridge an income gap until Medicare or Social Security full retirement age.
Diversification: Timeline and Process
You may begin to diversify shares in your ESOP account when you reach age 55 and have 10 years of service. During ages 55 to 59 you can elect to sell up to 25% of the vested cumulative shares in your account. At age 60 and over, the limit is increased to 50% of the vested cumulative shares in your account. Most ESOPs allow proceeds from the shares to be transferred into the company 401(k) plan, rolled over to another qualified retirement plan, or moved to your IRA (individual retirement account). Or, you may request a payment be made directly to you. If you request a direct payment and do not roll over to a qualified, tax-deferred, retirement account, you are responsible for taxes and penalties when you file your tax return for the year you received a payment.
Example: 25% ESOP Diversification with $100-per-share value and 1,000 shares at age 55
Age 55 | Cumulative Shares | Amount at $100 per share |
ESOP ending balance | 1,000 | $1 million |
Elect 25% diversification | -250 | $250,000 |
Balance after diversification | 750 | $750,000 |
In the above example, $250,000 could be rolled to a 401(k) or IRA, or a check for $250,000 could be requested. If a check is requested, the individual would be required to pay income tax and penalties (if under age 59 ½). An individual could diversify less than 25% of their shares and continue to have the opportunity to diversify in future years.
Keep in mind that depending on your company’s ESOP plan year, it could take up to eighteen months to receive a check. It’s important to diversify early or have other funds available if you are counting on your ESOP payout for immediate needs. Ask your plan representative about timing.
Diversification: Choices and Taxes
When making your diversification request, you can designate the form of payment. The following options should be available to you. Check with your ESOP representative to confirm.
Option 1: Rollover.
Make a direct rollover of your distribution to another qualified retirement plan (401k) or individual retirement account (IRA), and continue to defer paying taxes. You can also opt to receive a check, in which case you have 60 days after the check is issued to roll the money into another qualified retirement plan or IRA to defer paying taxes.
5 Reasons To Rollover Your Diversification Proceeds To An IRA Account:
You'll continue to grow wealth by investing in a variety of stocks, bonds, ETFs, or mutual funds.
You'll have many more investment options than with a 401k account.
Your IRA's financial advisor can help you with investments and forecasting retirement income.
You'll spread the taxes owed on the stock over many years instead of paying a large amount all at once, often at a higher marginal tax bracket.
Using planned withdrawals from your IRA, you’ll be able to create a steady retirement income to replace your paycheck.
If you do not elect a direct rollover and receive the payment by check, you have 60 days after the check is issued to roll the money into another qualified retirement plan or IRA to defer paying taxes. We recommend that you elect a direct rollover to avoid misplacing the check.
Option 2: Direct Payment.
Elect to receive a direct payment and pay applicable taxes and early withdrawal penalty (if any, applies under age 59 ½).
Five Reasons To Spend Your Diversification Proceeds
You and your spouse have enough saved that spending the cash won’t hurt your future retirement income.
Your spouse or partner has a large pension, or other income stream, that is sufficient to meet your retirement needs.
You have credit cards or other debt with extremely high interest rates that you need to repay.
You have significant financial pressures that outweigh saving for retirement such as replacing a wrecked car, paying medical bills, or helping an aging parent.
You calculated the income tax plus applicable IRS penalties and are OK with paying that amount this year.
The Hybrid Approach: Spend Some/Roll over Some
Your company may provide you with an option to spend part of your diversification proceeds and rollover a portion to your IRA or company 401k account. Consult with your ESOP representative if you are interested in this option.
Want more information? Download Peak Wealth Planning’s guide to ESOP diversification and retirement income? Do you need to forecast the income your ESOP can generate? The Peak Wealth Planning team can handle that and manage your investments too.
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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.