Can You Roll an ESOP Into an IRA? Steps, Rules, and Tax Implications

An Employee Stock Ownership Plan (ESOP) allows employees to own shares in the company they work for, often as part of their retirement benefits. When leaving a job or retiring, participants may want to transfer these funds into an Individual Retirement Account (IRA) to maintain tax advantages and control over their investments. Mistakes in this process can lead to unexpected taxes and penalties, making it important to understand the rollover rules.

Eligibility to Roll an ESOP into an IRA

Rolling over an ESOP distribution into an IRA is allowed under IRS regulations, but only if it qualifies as an “eligible rollover distribution.” Lump-sum distributions of company stock or cash can be transferred, while periodic payments and required minimum distributions (RMDs) cannot.

Employment status and age also play a role. Employees still working for the company typically cannot roll over ESOP funds unless they qualify for an exception, such as reaching age 59½ or experiencing a disability. Those who leave the company due to retirement, termination, or resignation are generally eligible.

The type of assets in the ESOP matters. If the plan holds company stock, participants can roll over the shares directly or sell them first. This decision affects taxes, particularly if the stock has appreciated. The IRS allows for a tax strategy called Net Unrealized Appreciation (NUA), which lets individuals pay capital gains tax on the stock’s appreciation instead of ordinary income tax. However, rolling the shares into an IRA eliminates this benefit.

Types of IRA Accounts

Choosing between a traditional IRA and a Roth IRA depends on tax treatment, investment flexibility, and withdrawal rules. A traditional IRA allows pre-tax contributions, meaning rolled-over funds grow tax-deferred until withdrawals begin, typically after age 59½. Withdrawals are taxed as ordinary income, which may be beneficial for those expecting a lower tax bracket in retirement.

A Roth IRA, funded with after-tax dollars, offers tax-free withdrawals if certain conditions are met. Rolling over pre-tax ESOP funds into a Roth IRA triggers immediate tax liability, but future withdrawals—including earnings—are tax-free. This option appeals to individuals expecting higher tax rates in retirement or those who want to avoid RMDs, which traditional IRAs require starting at age 73.

IRA providers offer different investment options, including stocks, bonds, mutual funds, and exchange-traded funds (ETFs). Some also allow alternative investments like real estate or private equity. Fees, account management, and withdrawal flexibility should be considered when selecting an IRA provider.

The Rollover Process

A direct rollover, where the ESOP administrator transfers funds directly to the IRA provider, is the safest method. This keeps the transaction tax-deferred and avoids the IRS-mandated 20% withholding that applies to indirect rollovers. The account holder must complete paperwork from both the ESOP plan and the receiving IRA institution, specifying whether the transfer includes cash, company stock, or both.

If a participant receives a distribution check made payable to them instead of the IRA, the IRS treats it as an indirect rollover, withholding 20% of the taxable portion. To avoid taxes and penalties, the full distribution amount—including the withheld portion—must be deposited into an IRA within 60 days. Missing this deadline results in the withheld amount being taxed as a distribution, with a potential 10% early withdrawal penalty if the individual is under 59½.

For ESOPs that include company stock, participants may choose to roll over only part of their distribution while using NUA tax treatment on the remaining shares. This requires careful record-keeping and coordination with a tax professional. If stock is transferred in-kind, the receiving IRA must accept direct stock rollovers, as not all custodians allow them. If the stock is sold first, the proceeds must be rolled over as cash, eliminating any preferential tax treatment on appreciation.

Tax Consequences and Reporting

Rolling over an ESOP distribution into an IRA defers taxes, but proper reporting is required. The ESOP plan administrator issues Form 1099-R, detailing the amount distributed, the taxable portion, and any federal income tax withheld. If the funds were directly transferred to an IRA, the form typically indicates a non-taxable rollover. For indirect rollovers, any withheld amount must be reported and potentially reclaimed when filing a tax return.

If company stock is involved, tracking the cost basis is necessary for future tax calculations. Gains realized inside an IRA are taxed as ordinary income upon withdrawal, unlike taxable brokerage accounts where capital gains may be taxed at lower rates. This distinction affects long-term tax planning, especially for retirees expecting large withdrawals in high-income years.

Common Errors That May Invalidate a Rollover

Errors in an ESOP-to-IRA rollover can lead to unintended taxes, penalties, or disqualification of the rollover.

Missing the 60-day deadline is a common mistake, particularly in indirect rollovers. If the full amount is not deposited into an IRA within this timeframe, the IRS treats it as a taxable distribution, potentially triggering income tax and a 10% early withdrawal penalty for those under 59½. While the IRS may grant a waiver in cases of financial institution errors or unforeseen circumstances, obtaining one requires filing a private letter ruling, which is costly and time-consuming.

Rolling over ineligible distributions, such as RMDs or periodic payments, can also invalidate the transaction. The IRS does not permit these amounts to be transferred into an IRA, and mistakenly including them in a rollover can result in tax penalties. Mishandling company stock can also lead to the loss of NUA tax benefits. Consulting a tax professional before initiating a rollover can help avoid these pitfalls and ensure compliance with IRS regulations.