In today’s post I’m going to break a bit from the normal equity compensation topics and talk about ESOPs. I’ve had a few people ask me about these recently and thought if people are asking I should probably do a quick writeup on them. Plus, one of the largest ESOPs is near me with Davey Tree in Kent, OH.
ESOP stands for Employee Stock Ownership Plan. A simple explanation of an ESOP is that it’s a company-funded retirement plan that holds company stock in accounts for participants. It’s safe to say it is similar to a profit-sharing plan. ESOPs are not limited to private companies as public companies can have ESOPs too. I’m sure I will cover why ESOPs are so popular and why they are used in another episode, just know they are more common than you think. Last data I saw said there were roughly 6,600 ESOPs in the US representing nearly 11 million employees. That’s about 7% of the US workforce. I just wanted to give you a sense of how popular they are.
OFFICIAL ESOP DEFINTION
I gave you the simple definition of an ESOP, but a more detailed one is coming your way now. An ESOP is a qualified, defined contribution employee benefit plan that invests in the stock of that employer company. Just as a refresher, qualified means it meets Federal rules that qualify it to be a retirement plan, and provides certain benefits to participants and the employer, like tax advantages. Defined contribution simply means a defined amount is contributed to the plan regularly. Basically, you know what amount is going in. It is then up to the performance of the investments that determine what it is worth when you take it out. In the case of an ESOP, that performance is of the company stock. On the flip side you have defined benefit plans where you know what the value will be at the end. Think of an old school pension. But this isn’t that.
I’m pretty sure I don’t want to punish you by getting into the weeds with more technical explanation of how ESOPs are set up. This isn’t that kind of podcast as I don’t get involved in setting up ESOPs. The focus in this episode is on the individual participant end, so let’s get back to it.
BUT, Something to point out though with how ESOPs are set up. They are funded by company contributions. They are NOT funded by employees who are participating. I’ll stop now and get back onto more interesting points about ESOPs.
Let me share a few bullet-point highlights about ESOPs.
- Participation in an ESOP is typically for full-time employees who are at least 21 years old and have one year of service.
- As the company funds the ESOP, plan shares are then allocated to individual participant accounts.
- ESOPs cannot discriminate in favor of highly compensated employees. This means ESOP shares are traditionally allocated based on compensation. Of course, there are some workarounds, but we’re not going down that rabbit hole.
- Just like I stress with equity compensation - be sure to learn your vesting rules! This simply means how long before you have control of the account balance. It’s important to know these because if you leave before you are fully vested you will most likely forfeit any non-vested amount.
- When you leave the company is actually when you take control of your account as this is when you receive the company stock or the equivalent cash value. Here is a key point with ESOPs. Participants are not taxed on the stock in their accounts until they receive distributions.
- Think of the tax structure like a 401k in that there are no taxes until the funds are distributed. You do have the ability to maintain that tax-deferral status if you roll your ESOP balance into an IRA. Once the money comes out of the IRA it will be treated as ordinary income.
Like traditional equity compensation, ESOPs allow participant employees a direct way to participate in the success of their company and the associated stock. Something I have to stress is ESOPs are one tool in your retirement planning toolbox. I have done posts and preached before about Concentration Risk. This is not uncommon in the world of equity compensation. My point is to think about how much of your retirement planning do you want to commit to one company stock. 40%, 50%, 60%? It isn’t that unusual to see a retiree with a strong ESOP plan to retire with 85% of their net worth in that one company stock.
Sorry, I’m getting a little stressed just thinking about all that money in one stock. Again, just a reminder to pay attention to how much of your net worth is tied up to one stock. Yes, I know you may not be able to diversify it all away depending on your situation, but at least know what that number is. One hot tip though, many plans have rules that once a participant reaches age 55 and have ten years of service they can start diversifying a portion of their stock balance. As always, talk to your benefits people.
Okay, let’s hit some highlights on distributions because there are some unique rules here.
- When a participant hits normal retirement age (as defined by the plan), becomes disabled, or dies, the ESOP has to distribute vested benefits during the plan year following the event. So, don’t plan on leaving your funds in the ESOP for whatever reason.
- Now, if the person leaves for other reasons they actually have a few more years before the balance is forced out. In these cases, it extends up to six years.
- Distributions can take a lump sum form, which is exactly what it sounds like. Another choice is to do substantially equal payments over a several years, but no more than five years. You do have to take something out annually so no thinking you can wait until year five to get that lump sum.
- Distributions are made with cash or stock in some cases.
- There may be a delay in distributions depending on plan loans. Again, talk to your benefits people to see if this would apply to you.
- And as I mentioned before, you can roll your distribution to an IRA so you can continue to defer the taxes.
- Finally, the price of the company stock is the fair market value of the stock when the company buys it back from you. If you are taking it out over equal payments then the stock price is determined at the time of those equal payments. Regardless, when you leave the company will typically buy back their shares.
One last thing to mention as I promise I will cover it in another post soon. Depending on your situation, you may want to consider an NUA if you have highly appreciated stock in a workplace retirement plan, such as an ESOP. This stands for Net Unrealized Appreciation. NUA is an advanced financial planning technique that could potentially save you lots in taxes, which means keeping more of what you have made. You know what I like to say – It isn’t what you make. It’s what you keep!
While the NUA is a potentially great tax saving resource, it is not available for shares rolled into an IRA. The short version is, if you roll your highly appreciated stock into an IRA and then decide down the road you want to do Net Unrealized Appreciation it is too late. That ship has sailed. My point is – don’t just automatically roll the balance into an IRA without checking out your options. Again, this is an advanced financial planning technique for people who have highly appreciated stock in a workplace retirement plan. It doesn’t just have to be in an ESOP either, but since this post is about ESOPs I figured I would mention it. Because it is advanced, be sure to talk to a CFP® or even a CPA about the NUA route before you make any decisions on the appreciated stock.
Okay, that is more than enough about What is an ESOP for now. I have probably put you to sleep. While my clients find this boring, I’m pretty sure they are glad I find it interesting. Hey, at least I’m not a CPA. Just kidding to all my CPAs out there!
ANOTHER CEDAR POINT STORY
In today’s flashback, I’m going to keep it quick as I have gone on more than I expected with ESOPs. I’ll share a quick story about working at Cedar Point. Again, I worked on the train there which are steam locomotives. Our days were spent going around in a big loop. It took 15 minutes to do one loop. And working 12 hour shifts you did your best to pass the time.
One day the engineer I was working with decided to try and play a song or two on the steam whistle. Again, steam locomotive so the whistle was steam-operated and it was loud. Well, we tried a few songs and didn’t have much luck. Or maybe we did. We did our round and when we came back into the main station the train manager, who was a full-time, year-round employee of Cedar Point was standing there waiting for us. Now this guy never came outside the engine house if he didn’t have to. That was a bad sign.
Apparently, a couple of the park VPs happened to be walking in the back of the park where the train ran and heard our attempt at a concert. And because they were corporate guys they did not appreciate our musical renditions. The nice thing for us was we were too hard to replace as no one liked working on the train because it was so hot, dirty and complex, but we did get a warning if we did it again we were gone. Just one funny story of many on the old Lake Erie express. I’ll tell you the story of that same engineer running next to the train another episode.
As always, thanks for taking the time to read this. Please do not hesitate to reach out if I can be of help with your equity compensation-related questions. The easiest thing to do is to click the little green box that reads “Schedule a Meeting” that can be found at the bottom of every page on my website. Or, just click my Calendly link right here.
I’m Dan Johnson, CFP®, founder of Forward Thinking Wealth Management. I run a flat-fee financial planning and investment management firm located in beautiful Akron, OH. Although I am in Akron, OH, I work with clients regardless of location. I cater to owners of equity compensation positions who are looking to organize their financial lives, keep more of what they make, and do the things they want in retirement and even now.