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Demystifying the Diversification of your ESOP Holdings

Updated: Oct 27, 2023

If you are an ESOP (Employee Stock Ownership Plan) participant it is imperative you consider when and what you will do once you are eligible to diversify your shares or receive distributions.

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An ESOP is a wonderful benefit from your employer. If you’ve been with the company long enough, you may have a significant amount of your net worth invested in your employer’s stock. This is all well and good if your company continues to grow. However, having a large concentration of employer stock could expose you to huge losses if things go sideways.

Take Kodak as an example. At one point, Kodak was the 5th most valuable brand in the world. Owning shares in Kodak seemed a sure thing. Unfortunately, when Kodak declared bankruptcy in 2012 employees participating in their ESOP program faced tremendous financial loss. In fact, this situation is why the IRS requires ESOP plans to allow employees to diversify a portion of their stock once they reach a minimum eligibility requirement. Often, the minimum is 10 years in the plan and age 55.

Companies use the term diversification when you sell stock back to the company while you are still working. Companies fulfill stock repurchase obligations, or diversification, when an employee reaches age 55, buying 25% of an employee’s stock, and another 25% again at 60. The employee’s remaining stock is repurchased during retirement across 5 years.

DIVERSIFICATION: Employee sells back 25% of stock at age 55 and again at age 60.
Companies use the term diversification when you sell stock back to the company while you are still working.

What you do with the cash you receive is up to you. You can pay the tax and spend what remains. Or, you can delay paying the tax and move that cash to an Individual Retirement Account (IRA). You can use your IRA to invest in a diversified portfolio. This is where the term diversification comes from. You move your nest egg from a single stock to many different stocks, bonds, or mutual funds. Diversification protects you from the risk that a single company may do poorly. And, diversification may help to protect and further grow your wealth.

Diversification happens while you are still working for the company while distribution happens once you retire from the company.

Companies use the term distribution when you sell stock back after you've retired from the company. At retirement you sell stock back to the company over a certain number of years, typically five. For example, you retire at age 65 and sell back one-fifth (20%) of your stock to the company each year during a five year period.  

Explanation of distribution of ESOP holding during first 5 years of retirement
Companies use the term distribution when you sell stock back to the company after retirement. During this time, you are no longer receiving new stock.

Similar to diversification, what you do with the cash is up to you. You can pay the tax and spend it immediately, or move the cash into a tax deferred IRA where you invest in a portfolio of mutual funds, stocks, and bonds.

How do I actually sell my shares back to the company?

At the end of each year, the company will send you a statement saying how much your stock is worth. Upon reaching the milestone age for diversification or retirement, the process for selling shares back to the company begins with the stock record keeper notifying you of eligibility. You’ll be asked to sign into a company website and complete a form. This form will indicate the number and value of shares eligible to be sold back to the company. Once completed, the company will issue a check. You can spend the check or deposit it to your IRA.

Why should I move cash from my ESOP diversification or distribution to an IRA?

  • Moving your ESOP cash to an IRA allows you to continue to grow your wealth for retirement by investing in a variety of stocks, bonds, and mutual funds. 

  • IRAs have many more investment options than 401k accounts and the mutual fund fees may be lower than your 401k. 

  • You can plan withdrawals from your IRA with the help of a financial advisor to create a steady retirement paycheck.

  • You can spread the taxes owed on your company stock over many years instead of paying a large amount all at once. 

How much risk is there with my ESOP concentrated stock?

Ideally, your ESOP is not the only wealth building vehicle in your portfolio. The more company stock you own, the higher your concentrated risk. 

Take these two extremely different retirement accounts as an example. Account A has a total of $500,000 in their portfolio with the ESOP account making up 20% of its overall value. If their ESOP flops overnight, they will still have 80% of their savings for retirement. Account B has a total of $4,000,000 in their portfolio with the ESOP account making up 80% of its overall value. If their ESOP flops overnight, they would have only 20% of their anticipated retirement savings. 

Account A has a total value of $500k with 20% locked into concentrated stock. Account B has a total value of $4 million with 80% locked into concentrated stock. Who is experiencing more risk?
Who is experiencing more risk?

As you near retirement it becomes essential to lessen your risk through diversification. Taking your concentrated stocks from the ESOP and moving it into an IRA will spread the risk among a variety of companies rather than just one.

Why should I invest cash from my company stock in an IRA instead of spending it?

If you cash the check, you may have a larger tax bill and ultimately less retirement income than if you move the proceeds to a diversified IRA account. Further, the temptation of spending all of the cash at once on a very expensive purchase may be too great to resist. 

Depositing the funds into an IRA will spread your tax obligations across many years, and allow the funds to continue growing. You should be able to take sustainable withdrawals from your IRA throughout retirement. When properly invested, your IRA should provide 3% to 5% of the value to withdraw for living expenses each year.  In the example shown below, at age 69 this person has $2.4 million in their IRA and could potentially draw about $90,000 per year. 

Your financial advisor can help you do this type of modeling or you can have the Peak Wealth Planning team create your customized Retirement Income Forecast.

What are the risks of running out of money during retirement?

The risk of running out of money could mean you need to take a reverse mortgage on your home (assuming it is paid off), move to a less expensive home or area, or lean on family for financial support. 

How much you spend each month relative to the total amount you have saved affects your potential to run out of money. As a rule of thumb, you should not spend more than 3% to 5% a year of your investments for retirement if you do not want to run out of money. 

Work with a financial planner to develop a retirement income projection. Mapping out your desired spending and aligning that with your various investments will set your mind at ease.

Timing of your action will greatly influence your income.

The choices you make will have a big impact on your retirement income. 

  • The time you elect to begin social security can make the difference between 20% less or 42% more monthly income. Gauge your anticipated life expectancy before committing to your start date.

  • The timing of selling your stock (ESOP) back to the company could dramatically affect your retirement. Typically following the diversification and distribution schedule is wise, but seeking the counsel of a financial advisor that specializes in ESOP distribution will provide you with additional insights. 

  • What you do with the cash from selling company stock back to the company can greatly impact the yearly income you receive during retirement.

Final thought.

Decisive actions you take today could make the greatest impact on your financial future. If you are uncertain or would like a second opinion regarding diversification of your company holdings, the Peak Wealth Planning team can assist.

Continue learning about ESOP:

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About the Author

Peter Newman is a Chartered Financial Advisor (CFA) and president of Peak Wealth Planning. He works with individuals nationwide that have accumulated wealth through company stock, ESOP shares, real estate, or running a business. Peter applies his unique background to help clients achieve their specific goals and enjoy peace of mind.

Peak Wealth Planning provides concierge services to meet your wealth management needs. Services include: financial planning, investment management, esop diversification, retirement income, insurance and estate planning advice, Peak Wealth Planning is a fee-based financial advisor in Champaign, Illinois.


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