Can You Transfer an ESOP to a 401(k)?
Transferring your employee stock plan to a 401(k) is possible under certain conditions, but involves key tax and financial trade-offs you must consider.
An Employee Stock Ownership Plan (ESOP) is an employee benefit plan that provides workers with an ownership interest in the company through investments in employer stock. This differs from a 401(k), a retirement savings plan where employees contribute to a portfolio of diversified investments. The ability to transfer assets from an ESOP to a 401(k) depends on specific circumstances and plan rules. Generally, such a transfer, known as a rollover, is permitted when an employee has a right to a distribution from the ESOP. These distribution events are governed by federal regulations and the specific terms outlined in the company’s official ESOP documents.
Understanding ESOP Distribution Rules
The primary trigger for receiving a distribution from an ESOP is separation from service, which includes quitting, being terminated, or retiring. Following a separation, the timeline for receiving your funds is dictated by the ESOP’s plan documents. For retirement, disability, or death, the plan must generally begin distributing your vested benefits in the plan year following the event. For employees who leave the company for other reasons, the plan can legally delay the start of distributions.
Under the Internal Revenue Code, a plan can wait until the sixth plan year following the year you terminate employment to begin payments. This delay helps the company manage its financial obligation to buy back shares from departing employees. Distributions from an ESOP can be paid in either a lump sum of cash or company stock, or through a series of substantially equal payments over a period of up to five years. The form of the distribution is important, as receiving company stock has unique tax implications, and the specific options available will be detailed in your plan’s governing documents.
The ESOP Diversification Requirement
A provision in federal law allows certain long-term employees to move a portion of their ESOP assets before they separate from the company. This rule, found in Internal Revenue Code Section 401, is known as the diversification requirement. It is designed to allow employees with a significant portion of their savings in company stock to reduce their risk as they approach retirement. To be eligible for diversification, an employee must be a “qualified participant,” defined as having reached age 55 and completed at least 10 years of participation in the ESOP.
Once an employee meets these criteria, they enter a six-year “qualified election period.” During the first five years of this period, the employee has the right to diversify up to 25% of the company stock in their account. In the sixth and final year, the right increases, allowing the employee to diversify up to 50% of their eligible stock balance, minus any amounts previously diversified. The plan can satisfy this requirement by distributing the value of the diversified shares or by allowing a direct transfer to another qualified plan, like a 401(k).
Executing the Rollover to a 401(k)
Once you have confirmed your eligibility for a distribution, you can begin the process of moving the funds to a 401(k). First, contact the plan administrator of your 401(k) to confirm that it accepts rollovers from an ESOP, as not all 401(k) plans are set up to receive these transfers. If the 401(k) plan accepts the rollover, the recommended method is a direct rollover, also known as a trustee-to-trustee transfer. You will obtain distribution paperwork from your ESOP administrator and provide the account information for your 401(k). The ESOP administrator will then send the funds directly to the 401(k) provider, which avoids any mandatory tax withholding.
An alternative is an indirect rollover, where the ESOP administrator sends you a check for your distribution. You have 60 days from the date you receive the funds to deposit them into your 401(k). A drawback of this method is that the ESOP is required to withhold 20% of the distribution for federal income taxes. To complete a full rollover, you would need to use your own funds to make up for that 20% when you make the deposit.
Key Tax Consideration Net Unrealized Appreciation (NUA)
A financial consideration before executing a rollover is a tax rule known as Net Unrealized Appreciation (NUA). This rule applies only when you take a distribution of actual company stock from your ESOP, not cash. The NUA tax opportunity is permanently forfeited if you roll the stock over into a 401(k) or an IRA. NUA is the difference between the cost basis of the stock (the price the ESOP paid for it) and its higher current market value.
When you use the NUA rule, you take a lump-sum distribution of your shares into a taxable brokerage account. At that point, you pay ordinary income tax, but only on the stock’s original cost basis. The NUA itself is not taxed until you decide to sell the shares, at which point that appreciated amount is taxed at more favorable long-term capital gains rates. For example, assume stock in your ESOP has a cost basis of $50,000 but is now worth $250,000. If you roll it into a 401(k), the entire $250,000 will eventually be taxed as ordinary income. If you use the NUA strategy, you pay ordinary income tax on only the $50,000 basis, and the $200,000 of NUA is taxed at the lower long-term capital gains rate only when you sell the stock.
The Rollover IRA as an Alternative
If your employer’s 401(k) plan does not accept rollovers from an ESOP, a common alternative is to use a Rollover Individual Retirement Arrangement (IRA). An IRA is a personal retirement account that you can open with nearly any financial institution, and they almost universally accept rollovers from qualified employer plans like ESOPs. The process for rolling ESOP funds into an IRA is identical to the 401(k) rollover process, using either a direct or indirect rollover. The direct rollover remains the preferred method to avoid tax withholding.
A primary advantage of using a Rollover IRA is the broader range of investment options compared to a typical 401(k) plan. While a 401(k) usually offers a limited menu of funds, an IRA allows you to invest in a vast universe of stocks, bonds, mutual funds, and exchange-traded funds (ETFs). This gives you greater control over your retirement portfolio.