401k vs. ESOP

If you're presented with a few retirement plan options, you might wonder, "What's the difference between a 401(k) and ESOP?" While a 401(k) plan is an employer-sponsored contribution plan that an employee and employer can make contributions to until an employee's retirement age, nn employer stock ownership plan is a trust established by a company, which allows employees to own shares of the company’s stock.

Companies offer 401(k) plans and ESOPs as incentives to employees. The characteristics of an ESOP vs 401(k) are vastly different. Managers and employees should understand the features, advantages and disadvantages of 401(k) plans and ESOPs to determine the best benefit plan for their situation.

How a 401(k) Works

A 401(k) plan allows employees to save for retirement by making tax-deferred contributions from their paychecks. Some companies match their employees’ contributions up to a certain percentage or dollar amount. The contributions placed in a 401(k) plan is used to invest in a variety of stocks, bonds, mutual funds and other investments. The performance of your 401(k) account is directly related to its underlying assets.

When you reach retirement age, you are granted the right to withdraw money from your account without incurring a penalty. You must pay income taxes on the money withdrawn. If you withdraw unapproved money from your retirement account, you must pay a 10 percent penalty.

Advantages and Disadvantages of a 401(k)

A primary advantage of a 401(k) plan is that your contributions are tax-deferred, which allow you to save more money in a shorter time period because of compound interest. Another advantage of a 401(k) plan is that the IRS allows individuals to contribute more to a 401(k) plan than an IRA.

A disadvantage of a 401(k) plan is that you are penalized for taking money out early and must pay taxes on early withdrawals. Other limitations include vesting requirements, which represent the length of time you must work at your job before receiving access to your 401(k) account.

How an ESOP Works

An ESOP is established when an employer creates a trust and makes annual contributions of new shares or cash to purchase new shares. The administrator of an ESOP is legally required to invest the majority of the money in the company’s stocks. The employer allocates the new shares to individual employee accounts based on employees’ compensation or length of service. The longer an employee works for the company, the more shares he accumulates.

When an employee separates from the company, the employer is obligated to buy back the shares of stock at market value.

Advantages and Disadvantages of an ESOP

When comparing an ESOP vs 401(k), you'll find that an advantage of an ESOP is that the benefit plan allows employees to take part in the profitability of the company. Another advantage is that employees are not obligated to pay taxes on contributions made into the account. An employee must pay taxes on withdrawals, but receives the option of rolling the money over into an IRA without paying taxes.

A disadvantage of an ESOP is that only certain business entities can establish the incentive plans. Partnerships and most professional corporations are not allowed to establish an ESOP. Another disadvantage is the expense to setup the plan is substantial, which makes it difficult to establish for many small businesses.