Are ESOP Distributions Taxable? Key Tax Rules Explained

Distributions from an Employee Stock Ownership Plan (ESOP) are taxable. An ESOP is an employee benefit plan that provides workers with an ownership interest in the company, and when you receive a distribution, it can be in the form of cash or company stock. The tax implications hinge on whether you receive cash or stock and the choices you make, such as rolling the assets into another retirement account.

Taxation of ESOP Distributions

If you receive a cash distribution, the entire amount is considered ordinary income for the year of the distribution. This income is taxed at your regular federal and state income tax rates, and the plan will report it to you and the IRS on Form 1099-R.

When you receive a distribution of company stock, you are immediately taxed at ordinary income rates, but only on the plan’s cost basis in the shares. The cost basis is what the ESOP originally paid for the stock. The increase in the stock’s value from that cost basis to its current fair market value is Net Unrealized Appreciation (NUA), and the tax on this portion is deferred.

Leveraging Net Unrealized Appreciation (NUA)

Net Unrealized Appreciation (NUA) is a tax planning opportunity for those receiving company stock. NUA is the growth in the stock’s value that occurred while it was held within the ESOP trust. To qualify, you must take a lump-sum distribution of your entire account balance from all of the employer’s qualified plans within one calendar year after a triggering event, such as separation from service or reaching age 59½.

The benefit of the NUA strategy is that tax on the appreciated value is deferred until you sell the shares. When you do sell the stock, the NUA portion is taxed at lower long-term capital gains rates, regardless of how long you held the shares. Any appreciation after the stock is distributed to you is subject to standard capital gains rules: short-term if sold within a year and long-term if held for more than a year.

For example, your ESOP distributes stock to you with a market value of $100,000. If the ESOP’s cost basis was $20,000, you would immediately pay ordinary income tax on that $20,000. The remaining $80,000 is the NUA, and you would not pay tax on it until you sell the stock, at which point it is taxed at the long-term capital gains rate.

Using Rollovers to Defer Taxes

You can roll over your ESOP assets to defer taxes. This involves instructing the plan administrator to directly transfer your distribution, whether cash or stock, to another qualified retirement account like a Traditional IRA. A direct rollover from the plan to the IRA is necessary to avoid complications.

The advantage of a rollover is continued tax deferral, as you do not pay tax at the time of the distribution. The assets can continue to grow tax-deferred inside the new account, and you will only pay taxes on withdrawals during retirement.

This decision comes with a trade-off. When you roll over company stock to an IRA, you permanently forfeit the NUA tax treatment. All future withdrawals from the Traditional IRA, including what would have been NUA, will be taxed as ordinary income. You must choose between taking the stock to use lower capital gains rates on the NUA or rolling it over for continued tax deferral at ordinary income rates.

Key Withdrawal Rules and Withholding

A 10% early withdrawal penalty may apply to ESOP distributions. If you receive a distribution before age 59½, you may owe an additional 10% tax on the taxable portion of the payout. Exceptions to this penalty include distributions due to death, disability, or a separation from service from the company during or after the year you turn 55.

Tax law mandates Required Minimum Distributions (RMDs) from your ESOP account. The starting age is 73 for individuals born before 1960 and 75 for those born in 1960 or later. You must take your first distribution by April 1 of the year after you reach the applicable age.

Mandatory withholding rules apply to distributions eligible for rollover. If you receive a cash distribution directly, the plan must withhold a flat 20% for federal income taxes. This is a prepayment, not your final tax liability, and you will reconcile the difference when you file your annual tax return.