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The In’s and Out’s of ESOP Diversification

Updated: Feb 17, 2023

If you’re working in an ESOP, married to an ESOP participant, or thinking about a job with a company offering ESOP as one of its employee benefits, you are bound to hear the phrase “ESOP diversification and distribution” a time or two.

But what does it mean? And, how will it impact you during your retirement planning?

This article will cover the company’s obligation to offer diversification, what you should anticipate happening when you are eligible to diversify beginning at age 55, how much of your ESOP you can diversify, and the options available for your cash at the time of diversification

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Employee owners should not rely solely on their ESOP for retirement. Doing so is the equivalent of putting all your eggs in one basket. Diversify your investments by funding your 401k, an Individual Retirement Account (IRA), and having cash available in savings accounts.

What is diversification in ESOP?

Within the world of employee ownership, diversification is the ability of a current employee stock ownership plan (ESOP) participant to exchange employer securities held in his or her ESOP account for cash or other investments. An ESOP participant typically qualifies for diversification when they have reached age 55 and completed ten years of service.

It is your employer’s responsibility to keep track of who should be given the election to diversify ESOP shares. Your employer will calculate the portion of the account eligible for diversification and provide you with a notice along with the number and value of your shares. If your employer does not comply with this requirement, this may result in a breach of fiduciary duty and possibly jeopardize the ESOP’s tax-qualified status.

ESOP Diversification

According to the Internal Revenue Code, each eligible ESOP participant (“Eligible Participant”) must be provided the opportunity to diversify up to 25% of her company stock account each year over a five year period, then increasing to 50% during the sixth and final year. These percentages are cumulative over the entire election period – it is not 25% each year in the first 5 years and then 50% in the sixth year.

An Eligible Participant is a current participant or former participant who has attained age fifty-five and completed at least ten years of participation in the ESOP.

The Eligible Participant must be given the right to diversify within 90 days following the end of the plan year in which he or she is eligible to diversify. If the Eligible Participant elects to diversify his or her account, the shares of company stock must then be diversified within the 90 days following his or her 90-day election period.

All shares of company stock previously diversified are included in calculating the required number of shares available for subsequent years. In other words, the shares of company stock previously diversified are added back into the account balance, then the applicable percentage (25%, or 50% if in the sixth year of the election period) is applied and the prior amounts are then subtracted from the result.

Timing Issues

Eligible participants who elect diversification should get paid within 180 days of the ESOP plan year’s end. Here’s how it works. Eligible Participants must make a decision whether or not to diversify a portion of their company stock account once they receive a notice from their employer. That notice should be sent by the employer within 90 days of the ESOP plan year’s end date. If the employee elects diversification, the trustee of the ESOP then has 90 days to diversify the Eligible Participant’s account.

Satisfying the Diversification Requirement

Most companies offer Eligible Participants the option to direct the ESOP to transfer (in cash) the portion of the account subject to the diversification election to one of the following:

  1. the company’s 401k plan,

  2. the participant’s IRA,

  3. receive a check the participant can cash.

The trustee of the plan is responsible to make sure the diversification is completed according to the employee’s direction.

Less Restrictive Diversification

Nothing in the Internal Revenue Code prohibits reduced diversification requirements, i.e., requiring five years of participation instead of ten. The cash position and financial condition of the company may warrant more liberal diversification. For example, an employer may want to provide for more liberal diversification to manage or spread out its repurchase liability obligations. Repurchase obligation is the requirement that a company buy back shares from eligible ESOP participants.

ESOP Plan Document Update

If the employer decides to allow for more liberal diversification, the ESOP plan document must be updated so everyone knows the terms of the plan. A company cannot implement a less restrictive diversification requirement through administration of the ESOP without a formal plan update.

Years of Participation

Most companies define a “year of participation” under the ESOP as a year in which an individual has an account balance under the ESOP, regardless of whether he or she is actively employed in such year. Some companies have a more strict definition of participation which means working for at least 1,000 hours. Your company’s ESOP plan document should define how it determines participation.

Employee owners should not rely solely on their ESOP for retirement. Doing so is the equivalent of putting all your eggs in one basket. Diversify your investments by funding your 401k, an Individual Retirement Account (IRA), and having cash available in savings accounts.

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 your retirement?

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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