It’s important to understand your options before making a decision to receive an ESOP distribution. Learn more about the benefits and tax consequences of ESOP rollovers, withdrawals, stock transfers and conversions. Meet with a qualified financial advisor to discuss your situation and make an informed decision aligned with your long term goals.
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When will I get a distribution from my ESOP?
To receive a distribution from your ESOP there must be a qualifying event. These qualifying events fall into two categories; ESOP distributions while still employed and ESOP distributions upon termination of employment.
There are only a few qualifying reasons by which employee owners still working for the company receive ESOP distributions:
- The company may choose to pay dividends directly to ESOP participants on the shares in their account
- The plan must begin distributing benefits to an ESOP participant whom reaches the age of 70½ and is a 5%-or-more owner of the company
- There are certain circumstances in which an ESOP may provide in-service distributions such as after a fixed number of years, upon reaching a specific age or due to hardship
It’s most common for ESOP distributions to take place upon the employee owner’s separation from employment with the company, whether due to retirement or other reasons:
- Upon retirement, disability or death, the ESOP must begin to distribute vested benefits during the plan year following the event unless an exception applies
- When employment terminates for reasons other than retirement, disability, or death, the distribution of ESOP benefits can be delayed up to the sixth plan year after the plan year in which termination occurred
- ESOP distributions may be delayed if the plan is leveraged (money was borrowed for the ESOP to buy company shares) distributions of ESOP-held shares acquired through the loan generally may be delayed until the plan year after the plan year in which the ESOP loan is fully repaid
What happens to my ESOP if the company is sold?
If your company is sold there may be special circumstances that affect your ESOP benefits. For example, plan rules or terms of the sale may dictate that participants in the ESOP become fully vested in all shares.
Usually when a company is sold the ESOP will terminate and employee owners receive cash proceeds for their company stock. This can present an opportunity to diversify into other investments and take more control of your funds outside the ESOP.
Keep in mind your ESOP is a type of retirement savings plan and the funds held in your account are pre-tax. To extend this benefit and avoid potential taxes and penalties you must take action to rollover funds to an IRA, 401(k) or other qualified plan.
In some cases, your company may be sold to a company with their own ESOP. Usually, this results in a rollover of some or all of your ESOP shares into the shares of the new company ESOP. In other cases, the acquiring company will cash out your shares and rollover the proceeds into an account for your benefit in a 401(k) or similar plan.
Understand that mergers and acquisitions take time. Even after your company accepts the terms of the deal, funds in the ESOP may be held in an escrow account until all remaining issues surrounding the transaction are completed. It is uncommon, but not unheard of, for a deal to not go through if issues can’t be resolved.
What are my ESOP distribution options?
ESOP distributions are made in the form of cash, stock, or a combination of both. ESOP distributions can happen all at once as a lump sum or split into substantially equal payments over a period of no more than five years. As of 2019 the five year period may only be extended if your benefit exceeds $1,130,000 (adjusted annually for cost of living).
Each ESOP distribution option has tax implications to consider. It’s important you understand the tax consequences before taking action, your decision may be irrevocable.
If a portion, or all, of your ESOP distribution is in cash, you have the option to take taxable withdrawals. Keep in mind the entire amount withdrawn is subject to ordinary income tax, and if you are under age 59½ there is an additional 10% early withdrawal tax penalty by the IRS.
Rollover to an IRA or qualified plan
To avoid paying taxes and potential penalties consider a rollover for your ESOP distribution. The rollover process takes place when tax-deferred funds from your ESOP are transferred to another tax deferred account such as an IRA or 401(k).
If you rollover funds to an IRA, also called a “Traditional IRA” or “Rollover IRA”, you will have the most control over managing and investing your funds. With an IRA you can decide how your money is invested, take cash withdrawals and even rollover funds to other accounts in the future.
If you rollover funds to a 401(k), or other qualified retirement plan, your funds will be subject to the rules of that plan. Refer to the plan document for investment options, withdrawal restrictions, fees and expenses.
You may choose to convert all or a portion of your ESOP distribution to a Roth IRA. Any amount converted is subject to ordinary income tax in the year the funds are converted. Roth conversions are not subject to the IRS 10% early withdrawal penalty. The potential benefit of a Roth IRA is that funds in the account can grow tax-deferred, then, in the future, qualified withdrawals are tax free.
Company Stock Transfer and NUA
If you receive company stock as part of your ESOP distribution you may be able to take advantage of the tax benefits of Net Unrealized Appreciation, or NUA.
NUA tax treatment is not available for all ESOP stock distributions. To qualify, you must receive a lump sum stock distribution of your entire account within one tax year, and you must not rollover that distribution to an IRA or other qualified plan. Additionally, the distribution must occur following one of these events: reaching age 59½, termination of employment, disability or the participant’s death.
The potential benefit of NUA tax treatment is that only the cost basis of the company stock is taxed at ordinary income rates. Any net unrealized appreciation of the stock (growth over time) is taxed at long-term capital gains tax rates, which is generally much lower than most participant’s ordinary income tax rate.