Employee stock ownership plans, or ESOPs, are qualified retirement accounts – similar to 401(k)s and 403(b)s – that your employer can offer to motivate you to make the company better and drive up the stock price while providing you tax benefits for retirement savings. The contributions aren't taxed, and the money grows tax free in the account. If you take early distributions, however, you might find yourself paying penalties.
Early Withdrawal Penalty
The Internal Revenue Service penalizes early withdrawals from ESOPs with a 10 percent additional tax on the distributions taken before you turn 59 1/2 years old. For example, say you leave your job at 40 and need some cash while you're looking for a new one. If you take out $20,000, you must add that extra $20,000 to your taxable income for the year and a $2,000 penalty on your taxes that year.
If you qualify for a penalty exception, you get out of the 10 percent penalty, but not the income taxes on the withdrawal. If you're permanently disabled or left the company after turning 55, you qualify for a penalty exemption, but still have to pay income taxes on the distribution. You also avoid the penalty – but not the income taxes – on the portion that was taken to pay an IRS levy on the account, a qualified domestic relations order or medical expenses exceeding 10 percent of your adjusted gross income.
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No Extra Contributions
When you cash out your ESOP, you're hamstringing your retirement savings and penalizing yourself. The IRS doesn't allow a larger contribution in future years to make up for early withdrawals, so once you've taken out the cash, you lose the tax-sheltered growth on those funds forever. If you've got a few decades before retirement, you might be able to make it up, but if retirement is right around the corner, you'll be hard-pressed to recover the earning potential of the money you withdrew early.
Instead of cashing out your ESOP after leaving the company, consider rolling it into another qualified retirement plan. For example, your new employer might offer a 401(k) plan that you can roll it into. If you don't have a new job, you can move it to a traditional individual retirement account. Either way, the transfer is tax free, because these are all tax-deferred plans. You won't pay the early withdrawal penalty, and the money continues to grow tax free.