• Peter Newman, CFA

The What, Why, How, and When of ESOP Ownership

Updated: Jun 30


Your company’s retirement plan mentions ESOP. You have heard your colleagues or HR talk about it for a moment. You are curious and want to know more. During the month of April, I have a series of articles that explore the basics of ESOP, the benefits of ESOP, the risk of concentrated stock ownership and how to reduce it, and explore tax strategy related to ESOP.

Let’s dive right into the overview of ESOP - Employee Stock Ownership Plan.

Binder with your Employee Stock Ownership Plan (ESOP) ready to be reviewed.
Your Employee Stock Ownership Plan is a valuable part of your overall retirement plan.

What is ESOP?

An Employee Stock Ownership Plan (ESOP) is a type of retirement plan that invests primarily in company stock and holds its assets in a trust for employees. The shares within the ESOP may represent 100% of the company stock, or may represent a portion of the company stock. ESOP participants (employees) accrue shares in the plan over time. Participants are paid out by having their shares bought back, typically when they leave the company.

Many ESOP participants utilize their shares as part of their retirement investments. Keep in mind that an ESOP is more than a retirement plan. An ESOP brings benefits to multiple stakeholders within the company and aligns their interests together.

Let’s explore a bit more.


Succession Plan for Retiring Business Owner

An ESOP is usually formed to facilitate succession planning in a closely held company by allowing employees the opportunity to accumulate stock over time. Instead of selling the company to a private equity firm or a competitor, a retiring owner sells to employees using an ESOP transaction. ESOPs are used by companies of all sizes including a number of large publicly traded corporations. See this NCEO infographic on how an ESOP transaction works. Retiring business owners can sell all or part of their company to their employees. This may allow for an owner to continue to be involved in the company while reducing his or her concentration of wealth and reward the employees who made the company successful.


Retirement Accounts for Employees

An ESOP enables employees to own part of the company they work for. Employees accumulate shares in their retirement accounts over time, and they can sell or ‘cash in’ those shares when they resign or retire. Yet the ESOP shares employees own never costs them a dime.


Incentive for Employee Owners

Since ESOP shares are part of the employees' compensation package, companies use ESOPs to keep employees focused on profitability and share price appreciation. Compared to 401K plans where the money is invested in other mutual funds, employees with an ownership interest are motivated to do what's best for shareholders. Having workers with a significant stake in the company can improve productivity and attitudes toward the company which may translate into better performance and more profits.

When the company does well, the ESOP participants do well.

Companies often provide employees with stock at no cost to the individual. The company may hold the granted shares in a trust for safety and growth until the employee retires or resigns from the company. The company may not distribute stock equally. Many companies only provide voting rights to particular shareholders. Companies may also give senior employees the benefit of more shares compared to new employees.


When Do ESOP Employees Get Paid?

Companies typically tie stock distributions to vesting—the proportion of shares earned for each year of service. Full vesting usually takes three or six years depending on the company plan. After becoming fully vested, the company "purchases" the vested shares from the retiring or resigning employee. The money from the purchase goes to the employee in a lump sum or equal periodic payments, depending on the plan. Employees can receive the sum and pay tax on the value. Or, employees can roll the funds into a tax deferred IRA or 401k.


Diversification Options

Employees who are 55 or older and have participated in the ESOP for at least 10 years are legally required to have the option of diversifying up to 25% of their ESOP account shares. Diversification happens when companies buy back employee shares in exchange for cash. This diversification option continues until age 60 at which time the participant must have the option of diversifying up to 50% of his or her shares.


What happens at retirement or separation?

ESOP plans are required to allow employees to retire at age 65, but some allow for earlier retirement. At the time an employee declares his or her retirement, most ESOPs distribute the value of remaining shares in substantially equal installments across five years beginning the plan year following your retirement date. This means distributions could start very soon or within two years depending on timing. It is important to consult with your financial advisor and human resources department to plan accordingly, especially if you are counting on distributions to fund living expenses.


If you leave for some other reason than retirement (such as quitting or being terminated), distributions of the value of your shares must begin no later than six years after the plan year in which you left. Companies may pay you out in a lump sum or over a 5 year period.


Continue learning more about ESOP diversification and distribution. Click here to access the Peak Wealth Planning white paper Demystifying the Diversification of Your ESOP Holdings.

Are you comfortable with your progress towards retirement?

If you are uncertain or would like a second opinion regarding diversification of your company holdings, schedule a call with me today.


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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 only financial advisor based in Champaign, Illinois.




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