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ESOP vs 401k: Understand the Differences

Updated: Feb 17, 2023

The Employee Ownership Foundation examined nearly 1,000 companies – half ESOP and half traditionally owned. Their findings? Employee-owned companies have a higher employee retention rate than their counterparts.

ESOP participants understand the key differences between their ESOP plan and 401k options.
Find confidence in knowing you’ve optimized your retirement plan.

One key difference between employee-owned companies and those within the public sector is the retirement benefits given to its employees. While most offer the option of a 401k with company contributions, employee-owned companies provide retirement benefits with shares of the company going into an Employee Stock Ownership Plan (ESOP).

Let’s examine the key differences between the ESOPs and the 401k.

How is my ESOP different from my 401k?

ESOPs and 401ks are designed to be long term retirement savings vehicles. They are not meant to fund your day to day living expenses during the years you are working. Instead, the investments provide a huge opportunity for compounded returns to grow your retirement nest egg.

Most business owners with 100 or more employees offer a 401k plan as a benefit. In the United States, more than 6,200 companies offer ESOPs covering 14 million employees.

The main differences between 401k plans and ESOP plans include:

  • Who funds contributions to the retirement account,

  • How much is contributed into the account,

  • What investments are available in the retirement account, and

  • When can you withdraw money from the account?

Key differences are outlined in the table below.

Key differences between an ESOP plan and a 401k plan. Answering the questions between who contributes to the plan, what amount may be contributed, the investment choices with the plan, and when money can be withdrawn.
Compare the key differences between ESOP and 401k

Assuming the accounts are not Roth, the main similarity between 401k and ESOP accounts is that investments grow tax-deferred with the intention of being used for retirement spending. This means that you do not pay tax until you withdraw the money for retirement.

The primary feature of an ESOP is that your investment is in employer stock.

Companies grant employees shares each year to motivate them to do what's best to make the company profitable. Whether that is saving on expenses or growing revenue, an employee-owner has a vested interest in seeing the company be successful. If the company does well, this benefits the company with profits and the employee by increasing their wealth.

However there are some risks with an ESOP that are generally not present within a 401k.

If your company falls on hard times and lays off employees, you could be looking for a job while the ESOP share price is down as well. If a company goes bankrupt, the ESOP portion of your nest egg for retirement could be wiped out.

It’s important to contribute to your 401k and IRA in addition to your ESOP. This reduces the risk of all your eggs being in one ESOP basket for retirement.

How do you reduce risk to your retirement? Offset risk of concentrated stock by funding IRA and 401k. Example of diversifying your retirement savings – 45% 401k, 25% IRA, 30% ESOP
Offset risks associated with ESOP by funding other retirement savings vehicles.

Think of a 401k as savings for your future with your employer helping out along the way.

The majority of employers in the United States, about 86%, provide some type of savings incentive by offering a contribution match on their employee’s 401k plans. No matter what your company’s match program is, it’s important to strategize. Contribute enough annually to maximize your employer’s contribution and potentially max out your annual contributions too (pre-tax contribution limits for 2022 are $20,500 or $27,000 for individuals over 50).

Within a 401k there are often a limited set of funds you can pick from with a mix of stocks, bonds, real estate, and international funds. You can pick the funds yourself or ask your employer’s 401k provider or your financial advisor with help selecting the funds.

The earnings within a 401k are usually tax deferred. This means you get a tax deduction for contributions you make and you don’t pay tax on the account until you spend money during retirement.

There is no vesting period for money added to your 401k. Once the funds are added, you have 100% ownership immediately. However, if you withdraw the funds prior to 55, you will face an early withdrawal penalty.

Employee Stock Ownership Plans (ESOP) is a Fully Funded Incentive Program

Employee Stock Ownership Plan (ESOP) is a savings vehicle for retirement. It is fully funded by the employer and offers the ability for employees to share in the company’s growth and profitability. The typical holding in an ESOP is company stock. This means that the employee’s income and wealth building from an ESOP are both tied to the company’s performance.

Should you withdraw from your ESOP before retirement?

Typically, you are eligible for diversification of your ESOP at age 55 or 60. This means you can take money out while you are still working. You can spend the money (after paying taxes and penalties) or reinvest it for retirement. The benefit of withdrawing before retirement is that you can pay off bills, fund a child’s college education, purchase a home, or take a trip to the beach. However, this may hurt your retirement nest egg.

If you rollover the money to an IRA or another 401k account, this delays spending the funds in favor of retirement. It provides you the opportunity to diversify your investment (and risks common from concentrated employer stock), and continue to grow your wealth while deferring your tax payment. Depending on the investments you choose, a rollover to an IRA or 401k can be a good option to allow your nest egg to grow for the future.

What about Roth?

Some employers offer Roth 401k or Roth ESOP options. With a Roth option, taxes on contributions are paid up front by the employee. And, when the funds are available for retirement, both the growth in the account and the original contributions can be withdrawn and spent tax free.

Are you an employee in an ESOP company?

Do you have more in depth questions about your retirement savings and strategy? Or do you have comments about what you just read?

I’d love to hear from you. Drop a comment below or schedule a call today.

Final thought.

Are you comfortable with your progress towards retirement? Are you confident you’ll know how to handle your ESOP diversification and distribution when the time comes? Do you need help visualizing how your ESOP can contribute to the retirement you visualize for your family?

Peak Wealth Planning meets with clients in Champaign and Chicago, Illinois, as well as in Colorado near Denver, Winter Park, and Fraser.

If you have a net worth over $2 million and need help from a wealth manager, the Peak Wealth Planning team can assist you.

Peak Wealth Planning specializes in helping high-net worth individuals and families plan for the future.

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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 based in Champaign, Illinois, and Fraser, Colorado.



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