What Is an Employee Stock Ownership Plan?

An Employee Stock Ownership Plan (ESOP) is a unique type of qualified employee retirement plan that offers an employee ownership interest of their employer via shares of stock. According to the Aspen Institute, there are 10.1 million individuals that work at the 6,447 companies that have ESOP plans.₁ In total, ESOPs have amassed $1.8 trillion, which comes out to an average of more than $180,000 per worker.

ESOPs are utilized by publicly traded organizations and private companies. The Aspen Institute did a breakdown of how many publicly traded and private companies have ESOPs. There are about 8.8 million plan participants among the 580 publicly traded organizations that have ESOPs. From the nearly 5,900 private companies with ESOPs, there are 1.4 million plan participants. If you have an ESOP, review the National Center for Employee Ownership’s list of the 100 largest broad-based employee-owned companies in the U.S. and see if your company is on there.

How ESOPs Are Structured

ESOPs function as a trust that consists of company stock. While each employee owns shares of the company stock, the company’s board of directors or Retirement Plan Committee is typically tasked with managing the ESOP and acting as a fiduciary in that role. They’ll determine how much to contribute to the ESOP on an annual basis. ESOPs are structured to motivate employees to do their best work to benefit their company, which would in turn benefit the employees since they hold shares of their company’s stock.

While ESOPs are governed by many of the same regulations and laws as 401(k)s, The ESOP Association states that ESOPs generally offer more benefits to the employee owners, companies, selling shareholders, and communities.₂ A 401(k) is funded through employee contributions, whereas an ESOP is funded by the company. Therein lies the motivation for employees to give their all since the success of the ESOP is contingent on the company’s success. Keep in mind that with your ESOP consisting of company stock, the value of your ESOP will be subject to economic conditions and customer demand.

Vesting in ESOPs

ESOPs typically have vesting schedules that outline when plan participants are granted 100% ownership of their allocated shares. The process of vesting can take place in one of two ways. There’s graded vesting that can occur over a few years—vesting X% each year for a set number of years until becoming fully vested. Then, there’s cliff vesting in which you would be 0% vested up until attaining a certain number of years of service, and at that point become 100% vested.

There are a few exceptions to those two types of vesting schedules.₃ If you pass away, become permanently incapacitated, have your ESOP terminated, or turn 65, your ESOP may be fully vested immediately.

Our advisors talk a lot about the importance of having diversification among your investments. Putting all your eggs in one basket—in this case, your company’s stock—poses a lot of risk. With ESOPs, plan participants are allowed to diversify 25% of their cumulative vested shares of company stock if they attain age 55 and have participated in the ESOP for at least 10 years.₄ That increases 50% of cumulative vested company shares at age 60.

Rollover Options

To achieve diversification after attaining age 55, you would sell shares of your ESOP at fair market value and roll them over into a traditional IRA or 401(k) or transfer the value of their stock to mutual funds within the ESOP plan. ESOPs have similar tax treatment as IRAs and traditional 401(k)s in that employee contributions are tax-deferred. That means that those contributions won’t be taxed until you take money out of the plan. Just like with IRAs, there is a 10% penalty if you withdraw funds from your ESOP prior to attaining age 59.5.

Also, keep in mind that ESOPs typically have a separate part of the plan that has a set fund line up to choose from, similar to a 401(k). It’s important for people to pay close attention to ESOP plan communications. The diversification window may only open one time each year for a limited period, so don’t miss that opportunity. Consult with a CFP® Professional regarding if diversification is the right decision before the window is open.

What Happens to Your ESOP Once You Retire?

With ESOPs functioning as a qualified retirement plan, it’s important to understand what will happen to the plan once you retire. As we mentioned earlier when talking about how ESOPs are vested, you may be eligible withdrawal funds from your ESOP upon your retirement (if you retire after attaining age 65). If your ESOP has accrued $5,000 or less, you’ll receive a lump sum distribution. If your ESOP balance is larger than $5,000, you’ll likely be paid over the course of five years in annual installments.

Make sure to confirm the payment schedule/amounts with your employer’s ESOP representative, as it can vary depending on the company. Also, keep in mind that you’ll be required to start taking distributions from your ESOP at age 73.

Net Unrealized Appreciation

We can’t write an article on Employee Stock Ownership Plans without mentioning Net Unrealized Appreciation (NUA). NUA pertains to the growth of your company’s stock within the ESOP. It’s calculated by determining the market value of the stock when you receive the distributions and the cost basis when the shares of stock were initially funded by the ESOP. The difference (AKA, the appreciation) in those totals may be taxed at capital gain tax rates, which can be much lower than ordinary income tax rates. However, there are requirements that must be met to benefit from the special NUA tax treatment.₅

The distribution from your ESOP must be completed after you turn 59½, leave your company (voluntarily or involuntarily), or after you pass away.
It needs to be a lump sum distribution.
The company stock shares have to be distributed from your ESOP plan “in-kind.” That means they must remain managed as company stock shares and can’t be liquidated.

It’s also important to note that NUA generally just pertains to employees who work at publicly traded companies. That’s because there may be restrictions on distributions for company stock shares from privately traded companies. Even instances in which a private company’s stock is transferable, there are still limitations that come along with holding it outside of the ESOP that leads to complications with taking advantage of NUA.

Employee Stock Ownership Plans vs. Employee Stock Purchase Plans

We want to make sure that you don’t confuse ESOPs with Employee Stock Purchase Plans. ESPPs offer employees the option to purchase discounted shares of stock, ranging from 5% to 15% of market value.₆ ESOPs presents that opportunity at no cost to employees. While all ESOPs are qualified, there are qualified and non-qualified ESPPs.

ESPPs don’t have vesting periods. However, employees with ESPPs may still need to work for a certain time period prior to participating in the plan. ESPPs also typically have shorter offering periods and aren’t as commonly used as a retirement benefit like ESOPs are.

Different ESOPs Have Different Rules

If you have an ESOP, make sure to read and understand the terms of it. Your ESOP could have slightly different rules than the ESOP your friend has with a different company. ESOPs can be complicated to understand, but they can be a powerful tool to build financial wealth during your career. If you have questions about what we’ve covered and/or questions about your ESOP, start a conversation with our team below. We look forward to the opportunity to meet with you about how your ESOP fits into the bigger picture of your financial life.

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Other Sources

[1] https://www.aspeninstitute.org/blog-posts/employee-ownership-and-esops-what-we-know-from-recent-research-2/

[2] https://www.esopassociation.org/what-is-an-esop

[3] https://www.kiplinger.com/personal-finance/how-an-employee-stock-ownership-plan-esop-works

[4] https://www.irs.gov/retirement-plans/employee-stock-ownership-plans-new-anti-cutback-relief

[5] https://www.kitces.com/blog/net-unrealized-appreciation-nua-employee-stock-ownership-plans-esop-capital-gains-income-tax/

[6] https://finance.yahoo.com/news/employee-stock-purchase-vs-ownership-135217205.html

Investment advisory services offered through Modern Wealth Management, Inc., a Registered Investment Adviser.

The views expressed represent the opinion of Modern Wealth Management a Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.