A benefit program known as an employee stock ownership plan, or ESOP, allows employees of a company a share in the company’s shares. Ownership can be acquired by employees in a number of ways, including by giving them company stock or by allowing them to directly purchase the firm’s shares.
For employees, ESOPs offer an alternative to traditional stocks and bonds for saving for retirement. Through ESOP programs, staff members can make direct investments in the businesses they work for and, after reaching the age of 59 1/2, potentially profit from profits on company stock. Although there are few situations where employees can pay out their profits earlier, most ESOP participants do so upon retirement.
An overview of these plans’ operation and recommended applications is provided below.
How is an ESOP structured?
A particular kind of defined contribution plan with a focus on retirement is an ESOP account. By 2020, there will be more than 14 million participants in approximately 6,500 ESOPs, according to the National Center for Employee Ownership (NCEO).
A business first creates a trust fund into which it puts either company shares or money to purchase them in order to form an ESOP. The business may also borrow money to buy stock through the trust and then subsequently contribute funds to the trust to pay back the loan.
Then, shares in this trust are dispersed and assigned to corporate personnel. In some schemes, employees can use their 401(k) to invest in company stock, or the ESOP may match the employee’s 401(k) investment with company stock.
When shares are provided to an employee, they may be retained under a trust on their behalf until retirement or resignation. Similar to how a 401(k) employer match can be related to a vesting schedule, the distribution of shares may likewise be determined by it. An employee will have complete ownership rights to their shares once they have reached the full vesting period, which varies according on the organization.
Vesting may take place instantly (immediate vesting), over a specific time frame (cliff vesting), or gradually over a number of years (gradual vesting.)
When are ESOP shares available to employees?
Since ESOPs are regarded as defined contribution plans, there are restrictions governing when shareholders will have complete access to their funds.
The value of the shares an employee was allotted and the number of shares they received will determine how much they will receive. Only until they have fully vested, in accordance with their company’s vesting timetable, will the full number of shares be accessible.
An ESOP payout can be given to a worker after their employment with the company ends in the form of shares, cash, or a combination of both. Usually, the employee sells the shares to the ESOP plan, who then buys them back and pays the employee the cash value of the shares.
Typically, an annual valuation is used to evaluate the shares’ fair market value. The price is disclosed to all shareholders, and this is what they can anticipate receiving in the event that their shares are liquidated.
Payments might be made completely at once or gradually over (usually) five years. Equal installments are given out for longer-term payments.
How soon will I receive my ESOP funds?
The plan agreement that the employee signed states that the employer must start making payments after a specific amount of time, albeit there are some exceptions.
Remember that ESOPs are qualified retirement plans and are subject to a 10% penalty if funds are used prior to reaching the age of 59 12 years old. Dividends distributed through the ESOP, however, are exempt from this penalty tax.
Employees must receive their first payment from an ESOP plan during the next plan year if they reach the plan’s normal retirement age (which, in the case of an ESOP, generally cannot be later than 65).
Another exception is that employees who leave the company or are fired must start receiving dividends no later than six years from the year they did so.
Many times, plans permit persons who have been terminated to start receiving distributions at age 55 without incurring a penalty tax. Similar to how 401(k)s occasionally permit it, ESOPs occasionally permit employees to borrow against their plans.
Mutual tax advantages
Tax advantages associated with ESOPs are advantageous to both the corporation issuing the plans and the employees receiving the shares.
Contributions made by the business to the ESOP trust fund are tax deductible for the business. The corporation can often deduct the fair market value of the shares from its taxable income if stock is deposited into the trust. Additionally, businesses can contribute tax-deductible funds to the ESOP trust that will subsequently be used to buy shares on behalf of their employees.
On their contributions to the account, employees do not pay taxes. Only after the account is distributed do the employees pay taxes, and even then they may be given an advantageous tax treatment. Rolling over ESOP distributions into an IRA or another tax-advantaged retirement plan may result in future earnings being taxed as capital gains rather than income, potentially saving a large amount of money.
Profit-sharing programs versus ESOPs
How do ESOPs compare to another well-liked benefit, profit-sharing plans? Although there are many parallels between the two plans and a profit-sharing plan is still considered an employee benefit plan, there are also some significant differences.
Similar to ESOPs, profit-sharing plans are incentive-based, but employees in a profit-sharing plan receive a portion of the company’s profits. If any earnings are to be given out in that specific year at all, the corporation selects what portion to provide.
Profit-sharing plans also give businesses the option to put pre-tax money into a trust for employees, and they also provide tax advantages for employees. Profit-sharing plan payments are not subject to Medicare or Social Security tax, which ultimately benefits the employee more. Profit-sharing plans fall under the same penalty regulations as ESOPs and other similar retirement accounts and are also regarded as defined contribution retirement plans.
Profit-sharing payments are often made in cash and invested in assets other than business stock. ESOP programs, on the other hand, make investments in the business and in what employees are already keenly aware of: their own daily labor.
Advantages of ESOP plans
ESOPs can give employees a stable financial base. According to a 2021 NCEO poll, companies with ESOPs gave employees more financial security before and throughout the pandemic, including higher job retention, compared to comparable companies without ESOPs.
Employee financial wellness and employee retention are both enhanced by ESOP plans. According to the NCEO survey, compared to non-ESOP employers, businesses with ESOP plans kept or added, on average, 6 more employees between 2019 and 2020.
Additionally, businesses give more to ESOP plans than they do to 401(k) matches. The average yearly employer contribution to a S ESOP (an ESOP owned by a S corporation) plan was 2.6 times higher than that of businesses solely offering a 401(k), according to the same NCEO survey (k). Compared to just 31% for 401(k) plans, the issuing business made up over 94 percent of all ESOP contributions.
Additionally, there is a chance for greater payments while taking part in ESOP plans. According to the NCEO, employees have an estimated $67,000 more in retirement assets in their ESOP account balances than workers at the typical company.
ESOPs frequently offer a market for shares held by departing firm members, like an owner or the majority partner. According to the NCEO, this is the rationale for almost two-thirds of ESOPs.
To sum up
It’s a good idea to take advantage of the option to participate in an ESOP plan if you have the means to do so. Employee stock ownership plans (ESOPs) provide employees a stake in the business they work for every day, encourage them to act in the best interests of all shareholders as they are also shareholders, and increase financial stability. ESOPs can be a terrific addition to retirement savings, despite the fact that they have the same restrictions as the majority of defined contribution plans.