What Is an ESOP?

Some employers offer an Employee Stock Ownership Plan as part of their retirement plan options. An ESOP allows workers to have shares of the company’s stock. If you’re given the chance to participate in an ESOP, you’ll want to understand what’s involved before moving forward. While there are potential benefits for participants, there are some risks to consider as well.

When reviewing an ESOP plan, consider:

— How ESOPs work.

— Pros of ESOPs.

— Cons of ESOPs.

— How ESOPs differ from 401(k)s.

— How to tell if an ESOP is right for you.

What Is an Employee Stock Ownership Plan?

Commonly called an ESOP, this is a type of qualified retirement plan. “Specifically, an ESOP is a trust that holds shares of stock of the sponsoring employer company,” says Michael J. Weaver, a managing member at Vandenack Weaver Truhlsen, a law firm in Omaha, Nebraska. “Those shares are held for the benefit of the employees of the company, making those employees beneficial owners of the company that employs them.”

[READ: Retirement Accounts You Should Consider.]

How ESOPs Work

When a company wants to create an ESOP, it designs a plan and trust documents. There will be an individual account formed for every employee who participates in the ESOP. The shares of stock are allocated to the accounts and accrue over time.

“How that allocation is made depends on the allocation formula set forth in the plan,” Weaver says. “The most common method of allocation is to allocate the shares of company stock based on each participant’s annual wages for the year.” For example, if an employee’s pay for the year is equal to 4% of the total pay given to all employees for the year, the individual will be allocated 4% of the company stock.

An ESOP also includes a vesting schedule, which lays out when funds will be owned by the employee and not the firm. “There are two basic methods for vesting that are permitted,” Weaver says. One involves a six-year vesting schedule, with 20% vesting per year starting after two years of service. This leads to 100% vesting after six years. The second type has no vesting for the first three years of service. After that, the account is 100% vested. “The ESOP plan may adopt a more rapid vesting schedule but cannot adopt one that is longer,” Weaver says. Participants will receive their vested portion when they leave the job, such as at retirement.

[Read: How Much Should You Contribute to a 401(k)?]

Pros of ESOPs

There are tax advantages associated with this type of retirement plan, including that employees can receive a tax-deferred account. This means participants won’t pay tax on the stock allocated to their accounts until they receive distributions. “For employees, they get to share in the company’s future growth and success,” says Martha Sullivan, a certified public accountant and president of Provenance Hill Consulting in Waunakee, Wisconsin. “If the company grows substantially over time, this retirement investment grows in parallel.” The arrangement could encourage workers to stay for a longer time with a company. It could also motivate them to contribute positively to the company’s performance. “It is a fantastic way for family businesses to maintain connection and leadership opportunities for their next generation,” Sullivan says.

Cons of ESOPs

There is some risk with this type of retirement plan. Since the stock is tied to the firm, gains and losses could be reflected in the account. “If the company goes bankrupt, the employees may lose their retirement savings,” says Michael Collins, a financial advisor who teaches at Endicott College in Beverly, Massachusetts.

[Read: New 401(k) Contribution Limits for 2022.]

How ESOPs Differ From 401(k)s

While an ESOP holds stock of the sponsoring employer, a 401(k) can be invested in a variety of ways. Employers contribute to the ESOP, whereas a 401(k) typically includes money coming out of the worker’s paycheck to fund the account. In some cases, a 401(k) could have a company match up to a certain point. “Most companies that sponsor an ESOP also provide a 401(k) plan,” Weaver says.

How To Tell if an ESOP is Right for You

Before participating in an ESOP, you can review the company’s position. Start by checking if the firm is profitable. “Any debt associated with the acquisition of the stock in the ESOP will need to be repaid,” Weaver says. There will also be cash required to make payments when participants retire. Given this, a company with strong management that is not highly leveraged could have an ESOP with potential. A struggling firm with high debt and low levels of cash generation may not be an ideal fit.

Consider your other investments as well. “If this is the only holding one has for retirement planning, should the company experience a downturn or go out of business, the value of the stock would be eroded or completely wiped out,” says Aaron Maassel, owner and founder of Voyageur Advisory Group in Maumee, Ohio. “This is the equivalent of putting all your eggs in one basket.” If you have other investments and accounts, an ESOP could add diversification. “They are a great way to complement a traditional retirement investment plan that, done in conjunction with 401(k)s, insurance-based vehicles and after-tax investment accounts, can provide a well-rounded portfolio,” Maassel says.

More from U.S. News

How to Pay Less Tax on Retirement Account Withdrawals

10 Tax Breaks for People Over 50

12 Ways to Avoid the IRA Early Withdrawal Penalty

What Is an ESOP? originally appeared on usnews.com

Related Categories:

Latest News

More from WTOP

Log in to your WTOP account for notifications and alerts customized for you.

Sign up