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Summary

An Employee-Stock Ownership Plan, usually referred to as an ESOP (pronounced "e-sop"), is a defined-contribution retirement plan in which your employer contributes shares of stock of the company for which you work. You may also be able to purchase additional shares for the account using money deducted from your paycheck.

There are limits on the amount your employer and you can invest in an ESOP.

  • Some ESOPs allow you to contribute funds to purchase company stock. Employers often match these contributions. For example, for every dollar you contribute to buy company stock, your employer might contribute 10 cents, 50 cents or even a dollar.
  • There is a maximum you can contribute per year as well as a maximum that you and your employer together can contribute to an ESOP on your behalf.  The amount is adjusted for inflation each year.

Borrowing from an ESOP is not allowed.

Taking a distribution before retirement, is generally not allowed by employers although some plans do allow it. Check with your plan administrator or benefits office. (If you do get an early distribution in cash, and are under age 59 l/2, your distribution will be subject to income tax plus a 10% penalty for early distribution of the funds. If you are over age 59 l/2, you will only have to pay taxes on the distribution).

If you become disabled as defined by your Plan:

  • Your account usually becomes fully vested. However, your distribution might not begin for as long as one year form the date of your disability.
  • The value of your stock for tax purposes will be determined as of the date you leave the company.
  • If you are considering applying for a withdrawal due to disability see: How To Apply For A Withdrawal Due To Disability

Diversification: By law, once you reach age 55 and have at least 10 years of service, your plan must let you diversify at least 25% of your account into other investments. You must be given at least three investment choices. When you reach age 60, you must be allowed to diversify at least 50% of your assets. Consider taking advantage of the diversification. The value of your retirement account could have a significant downturn if the company stock suffers a decline. With diversification, you can reduce the risk - especially if you invest in industries that tend to go up if your industry goes down. Diversification is especially important if you believe you may be accessing these moneys in the near future.

If you leave the company before you retire, you may be able to take the vested portion of the funds with you, although the Plan may require passage of a period of time before payout starts.

  • If you leave your employer before you retire, you will retain ownership of the vested amount of your account. (The "vested amount" is the amount that belongs to you no matter what). However, the plan can hold the account until you attain retirement age under the Plan.
  • When the payout begins, you may have the option of taking either stock or cash.
  • You will also have the option to rollover your account to an IRA or transfer the ESOP directly to another retirement plan. There are special tax rules for stock distributions. It is advisable to speak to a financial advisor before rolling stock to an IRA.

On retirement, there may be a delay before you receive the funds. There are usually payout options for receiving the stock/money.

  • If you retire, you will receive your ESOP account value within one year of the date of your retirement, either in stock or the cash equivalent - unless the stock in the plan was purchased by a loan that is still in repayment status.
  • You can choose one of the following options:
    • Receive a lump-sum distribution (the entire value at once) and pay ordinary income taxes on the distribution  or rollover the distribution into an IRA account OR
    • If allowed by the plan, you may also have the option of having your ESOP paid to you over time. This alternative minimizes the amount of taxes each year. If you choose this option, the amount of money you receive is based on the value of your account when you retire, regardless of any future growth or loss in the price of the stock. OR
    • You can roll over the distribution into an IRA account. Rolling the funds into an IRA allows you to earn additional growth on the value tax free while in the account. Of course, always keep in mind that stocks can decrease in value.
  • To help decide which is the best option for you, it is advisable to consult with a financial advisor such as a Financial Planner. (To learn how to choose a financial planner, click here.)

Tax on distribution: On distribution, the value of your stock is taxed as ordinary income. If you continue to hold the stock and it goes up in value, the increase in value is taxed at capital gain tax rates when you sell.

If you die:

  • Your ESOP account will usually become fully vested and will be distributed to your beneficiary.  However, there may be a delay of up to five years  before distributions begin. The delay may be even longer if the stock in the plan was purchased using a loan that is still in repayment status.
  • If your spouse is your beneficiary, he or she may avoid paying immediate tax by rolling over the proceeds into his or her own IRA.  Other beneficiaries must pay ordinary income taxes on the distribution. (For information about IRA rollovers, click here.)

For information about:

  • ESOPs and taxes, click here.
  • How To Apply For A Withdrawal For Disability, click here
  • How To Apply For A Withdrawal For Hardship, click here.

NOTE: If you have an ESOP, be sure your beneficiary designation is up to date.

ESOPs And Taxes

Contributions:  You do not pay income tax on the value of the stock that your employer deposits in an ESOP on your behalf, or on the contribution you make to buy shares for the account.

Dividends: You may also receive dividends from the stock you have in the account. These dividends will not be taxable while the stock remains in the account.

Distributions: When the stock is distributed from an ESOP, the distribution will be subject to ordinary income tax based on the value of the stock at the time of the distribution. This is so even if you don't sell the stock, although there are special tax rules for stock distributions.

Sale: When you do sell the stock received from an ESOP, any change in value since the time of distribution will be treated as a capital gain or loss. 

For example, suppose stock in your employer, XYZ Corporation, has been contributed to an ESOP account on your behalf for each of the last 10 years.  You left work on disability a year ago, when the stock was worth $50,000.

  • As the contributions were made to your account, there was no tax payable on amount of the contributions.
  • During the year when you went on disability, you had to declare the $50,000 as ordinary income even though the stock was not sold. 
  • If you decide to sell the stock this year for $60,000, the $10,000 difference between $50,000 and $60,000 will be subject to the capital gains tax.. 

NOTE: You could have avoided paying the tax on the increase if you had rolled the distribution into an IRA account and kept the sale proceeds in the IRA.

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More Information

IRAs

How To Apply For A Withdrawal For Disability

Check your Plan to find out if it allows for an early withdrawal due to disability If it does, it will generally include one of the following requirements.

  • You must qualify for disability under the Social Security laws such as Social Security Disability Insurance (SSDI). To learn what that means, as well as how to improve your chances of obtaining disability status, see: SSDI: 101.
  • The Plan may have its own definition of "disability." For instance, the plan may define disability as your being unable to do your current job (as compared to the more general definition in the Social Security law which relates to being able to do any job for which you are qualified). If a plan includes its own definition of disability, it usually only requires a doctor's written opinion stating that you are disabled. The plan may reserve to the administrator the right to confirm the disability - for instance, through direct contact with your doctor, by requesting a copy of your medical records, or by having a second opinion.

If you have questions about your Plan's definition of "disability," or how to qualify, ask your plan administrator.

The IRS has the right to question whether you are indeed disabled within the Plan's definition. However, as a general matter, the IRS seems to only check to determine if the plan has such an exception, not whether your particular situation fits the definition.

NOTE: Keep in mind that even though the amount of your withdrawal is not subject to penalty for early withdrawal, it is subject to ordinary income tax.

How To Apply For A Withdrawal For Hardship

To apply for a withdrawal from a retirement plan because of hardship, consider the following steps:

  • Step 1: Check your plan to determine whether an early withdrawal due to hardship is permitted.
  • Step 2: If hardship withdrawals are permitted, the plan will tell you how such withdrawals are defined. They may be limited to specific causes of hardship - such as medical expense or mortgage foreclosure.
  • Step 3: If you think you can qualify for one of the permitted reasons, ask the plan administrator how that type of hardship is defined. For example, if the reason is medical expense, don't be surprised if you have to present copies of medical bills for a period of time such as XXX months.

The IRS has a right to question whether you are suffering from a "hardship" within the Plan's definition. However, as a general matter the IRS seems to only check to determine if the plan has such an exception, not whether your situation fits the definition.

NOTE: Keep in mind that the amount of your withdrawal due to a "hardship" is subject to a penalty for early withdrawal, as well as being subject to ordinary income tax.

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