Is an ESOP Considered a Retirement Plan?

An Employee Stock Ownership Plan (ESOP) is an employee benefit plan giving workers an ownership stake in their company. This article clarifies ESOPs’ structure, their role in retirement savings, tax implications of payouts, and other employee considerations.

The Structure of an ESOP

An ESOP is formally structured as a trust. The ESOP trust legally owns company shares, managed by a trustee for all participants.

Companies can fund the ESOP trust by contributing newly issued shares, cash to purchase existing shares, or by borrowing money to buy a large block of shares. When leveraging a loan, the company makes tax-deductible contributions to the ESOP, which the trust then uses to repay the debt. These shares are subsequently allocated to individual employee accounts within the trust, typically based on factors such as relative compensation or years of service. Employees do not directly pay for these shares; instead, the company funds the plan on their behalf.

ESOPs and Retirement Savings

An ESOP functions as a retirement vehicle, offering wealth accumulation through company ownership. Employee accounts grow as more shares are allocated and as the company’s value potentially increases over time. Employees gain increasing rights to the shares in their account through a process called vesting, which typically requires full vesting within three to six years. Once vested, employees become eligible for distributions from their ESOP account upon specific qualifying events, such as retirement, termination of employment, or disability. These distributions are generally paid out in cash, though some plans may distribute company stock.

ESOPs share similarities with traditional retirement plans like 401(k)s and Individual Retirement Accounts (IRAs), particularly in their tax-deferred growth. Like these plans, an ESOP allows the value of the shares to grow without immediate taxation until distribution. ESOPs also differ significantly in investment diversification, as they are legally required to invest primarily in the sponsoring employer’s stock, concentrating an employee’s retirement savings in a single asset. In contrast, 401(k)s and IRAs typically offer a broad range of investment options, allowing for greater diversification.

Taxation of ESOP Payouts

ESOP distributions are generally taxed upon disbursement. The typical rule is that these payouts are taxed as ordinary income upon receipt. This means the distribution is added to an employee’s taxable income for the year it is received and is subject to their marginal income tax rate.

Employees have options to defer or reduce this tax liability. Distributions can often be rolled over into another qualified retirement account, such as a Traditional IRA or a 401(k) plan, to defer taxation until future withdrawals are made from the new account. If a distribution is rolled into a Roth IRA, the amount rolled over is taxed at the time of the rollover, but qualified withdrawals in retirement are then tax-free.

Net Unrealized Appreciation (NUA) can apply if an ESOP distribution includes company stock. If the stock is distributed in a lump sum and then transferred “in-kind” to a taxable brokerage account, the employee pays ordinary income tax only on the original cost basis of the shares. Any appreciation in the stock’s value while held in the ESOP (the NUA) is taxed at the lower long-term capital gains rates when the shares are eventually sold, rather than at ordinary income rates. To qualify for NUA treatment, the distribution must be a lump sum, occurring after a “triggering event” such as separation from service, reaching age 59½, or death.

Employee Participation Considerations

The value of ESOP shares is determined through an annual valuation process conducted by an independent appraiser. This appraisal establishes the fair market value of the company’s shares, which is the price at which the company will repurchase vested shares from employees upon their departure. The Department of Labor and the IRS require this annual valuation to ensure fair pricing and compliance.

Diversification is an important consideration within an ESOP, as retirement savings are concentrated in a single company’s stock. Employees who reach age 55 and have participated in the plan for at least 10 years typically gain the right to diversify a portion of their ESOP holdings. This allows them to move a percentage of their vested shares out of company stock and into other investment options or receive a cash distribution. Participants may diversify up to 25% of allocated shares during ages 55-59, and up to 50% from age 60 onward.

The ESOP trustee generally holds the voting control for the shares within the trust. In private companies, employees typically have limited direct voting rights, usually restricted to major corporate events like a merger or sale of substantially all company assets. For publicly traded companies with an ESOP, employees must receive the same voting rights as other shareholders.