A typical Employee Stock Ownership Plan (ESOP) enables all or some employees within a company to own its shares. Companies that offer this kind of employee benefit plan set up trust funds and contribute company shares or funds to buy the company’s stock. However, your ability to access the plan depends on the vesting period, which encourages employees to stay with employers for a while.
Because ESOPs are tax-deferred plans, you don’t have to pay any taxes on your contributions. But when you retire or leave and receive your share of the company stock, you will need to pay taxes. And should you withdraw your ESOP funds early, you may need to pay the ESOP early withdrawal penalty. So, you must understand what the rules are to avoid paying more than you should.
Read More: 401k vs. ESOP
How You Get Your ESOP Payout
You can cash out of your ESOP when you leave, get fired, become disabled or retire. However, the vesting period must be over for you to receive everything due to you. That period is usually about four years after the first year of work, regardless of an employee’s position within the company.
When you leave, you can get your payout in the form of cash, stocks or a combination of both. And it could be in the form of installments or a lump sum. However, your employer can purchase your shares at the fair market value and give you all cash if you choose to sell.
Handling an ESOP After Termination
If your previous employer offered an ESOP, you can take your vested shares or cash them in upon termination. And your employer is obligated to give you your distributions within six years after terminating you.
However, you must have a balance of at least $5,000 for you to have a say in what happens to your retirement funds upon termination. In such a case, you can cash in your stocks or let them remain in the plan until retirement age.
When you cash in your stocks, you can:
- Move them to another retirement account
- Have the employer distribute substantially equal payments over a five years
- Withdraw the funds to a different bank account
Read More: How to Cash Out of ESOP After Quitting
ESOP Withdrawal Age Requirement
According to the ESOP withdrawal rules, employees can generally begin taking distributions from the ESOP from the minimum age of 59.5 years. However, from the age of 55, some employees can start taking distributions, especially if terminated.
Those who have attained 55 years and have worked for the company for at least 10 years have the right to diversify at least 25 percent of their company stock for up to five years. They can also diversify up to 50 percent of their stocks by the end of six years.
ESOP Early Withdrawal Penalty
Suppose you begin your ESOP withdrawals earlier than 55 years if you have been terminated or 59.5 years if you retire and you are not disabled. In that case, you will pay an ESOP withdrawal penalty of 10 percent. That is on top of the ordinary income tax rate your distributions will be subject to.
ESOP rules also state that anyone who turns 72 must take the minimum required distributions (RMDs) from their ESOPs or risk facing a 50 percent penalty on the amounts not taken.
It is worth noting that dividends within ESOP accounts are fully taxed as ordinary income. However, they are not subject to income tax withholding. Nor are they subject to the 10 percent early withdrawal penalty.
In addition, if you are a qualified individual, you may be able to enjoy COVID-19-related early withdrawals of up to $100,000 from your ESOP. However, these distributions, which are based on the CARES Act, only apply to those who took them before December 31, 2020.
Final Thoughts on ESOP
If you want to avoid the ESOP early withdrawal penalty, you should only withdraw your funds if you are terminated at age 55 or older, have retired and attained 59.5 years or meet the COVID-19 CARES Act eligibility criteria. In addition, you can enjoy the ESOP dividends, which are not subject to the penalty. You could also cash in your stocks and roll them over to another retirement account within 60 days to avoid the early withdrawal penalty.
Also, disability allows you to withdraw your ESOP distributions early and without incurring the penalty. And should you die before reaching the minimum retirement age, your beneficiaries will access the distributions without paying the 10 percent early withdrawal penalty.
- ESOP.Org: Employee Stock Ownership Plan (ESOP) Facts
- Index Ventures: ESOP rules
- NCEO.Org: When Will I Be Paid? The ESOP Participant's Guide to ESOP Distribution Rules
- Mondaq: A Primer On ESOP Distribution Rules
- BKD: Understanding RMDs for Your ESOP Account
- NCEO.Org: ESOP Tax Incentives and Contribution Limits
- NAPA-Net.Org: CARES Act Administrative Q&As—COVID-19 Distributions
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