Many companies offer employee stock ownership plans or employee stock purchase plans as part of a benefits package. Both ESOPs and ESPPs give workers an opportunity to secure an interest in their company's stock, but in very different ways. If your employer sponsors an ESOP or ESPP, you need to know how each plan works to make sure you're getting the biggest return on your investment.
Employee Stock Ownership Plans
An employee stock ownership plan is a type of defined contribution plan recognized under section 401(a) of the Internal Revenue Code. Each employee has his own account, and your employer kicks in stock or cash that's used to purchase company stock. You don't actually buy or hold the stock directly as long as you're employed, and you have to wait until your shares vest before you can cash in on your investment. If you leave your job for any reason, including termination or if you retire, you automatically assume ownership of your shares.
Employee Stock Purchase Plans
Employee stock purchase plans are regulated under section 423 of the Internal Revenue Code. With an ESPP, employees are able to buy stock for less than fair market value without owing any taxes on the discounted amount. Typically, an ESPP is set up to allow you to purchase stock through after-tax payroll deductions. The amount of the discount varies, but it can be as much as 15 percent. Each company is responsible for setting its own guidelines to determine when you're eligible to enroll in an ESPP.
With an ESPP, you can elect to have anywhere from 1 percent to 15 percent of your pay withheld for stock purchases. The amount of stock you can purchase through an ESPP in a single year is capped at $25,000, as of 2013, though that could be subject to change. There's no specific limit on how much your employer can put into an ESOP on your behalf. Shares are divided among employee accounts based on factors such as pay or seniority. You become increasingly vested in the shares the longer you work for the company. IRS guidelines specify that employees must be 100 percent vested within three to six years of enrolling in the plan.
With an ESOP, you won't pay any taxes on contributions to your account, but any money you take out will be taxed at your ordinary income tax rate. Earnings accumulated over time would be taxed as capital gains. You also have the option of rolling over a distribution into an IRA or another qualified retirement without paying a tax penalty. If you take money from an ESOP before you turn 59 1/2, you'll have to cough up a 10-percent early withdrawal penalty on top of any taxes due. If you're enrolled in an ESPP, you're only subject to tax when you sell your shares. Depending on how long you held the shares, earnings may be subject to capital gains tax or ordinary income tax.
- National Center for Employee Onwership: How an Employee Stock Ownership Plan (ESOP) Works
- Internal Revenue Service: Employee Stock Ownership Plans
- Fidelity.com: FAQs - Employee Stock Purpose Plans
- Internal Revenue Service: IRS Announces 2013 Pension Plan Limitation
- Legal Information Institute. "26 U.S. Code § 423.Employee Stock Purchase Plans." Accessed Mar. 20,2020.
Rebecca Lake is a freelance writer and virtual assistant living in the southeast. She has been writing professionally since 2009 for various websites. Lake received her master's degree in criminal justice from Charleston Southern University.