ESOP vs. 401k: An Introduction

February 11, 2022

Ever since the establishment of the first ESOP in 1956, employee ownership has become a valuable tool for attracting and retaining top-tier talent that is loyal and vested in the success of the companies that hire them.

In fact, many companies offer ESOPs in conjunction with a secondary retirement plan, such as a 401k.

Offering retirement benefits such as a 401k plan or an ESOP is necessary for the competitive global marketplace, but which retirement vehicle is the best for your company? Here is a simple comparison between an ESOP and a 401k. Perhaps this can help in deciding what to offer your employees.

What is an ESOP?

An Employee Stock Ownership Plan (ESOP) is a tax-exempt trust that allows employees to take part in the ownership of their Company’s stock—both to incentivize their continued employment but also to enable them to directly benefit from their company’s success.

Research has conclusively shown that employee-owned companies can experience less employee turnover, higher employee satisfaction and productivity, and greater profitability and revenue growth than their non-employee owned peers. Additionally, the contents of an employee’s ESOP account is not subject to the daily volatility of the stock market.

What is a 401k?

A 401k plan is an employer-sponsored contribution plan to which both an employer and employee can contribute until the employee’s retirement age. 401K earnings are not taxed until money is withdrawn from the account. Additionally, this account is directly correlated with the ups and downs of the stock market.

ESOP vs. 401k: As a Qualified Retirement Plan

It is important for business owners to consider the value of the ESOP vs, 401k plans as a qualified retirement plan. While the ESOP and the 401k are both qualified retirement plans, the 401k is funded by the employee and sometimes matched by the employer, whereas ESOPs are funded exclusively with contributions of company stock.

This unique difference is what makes ESOPs a great option for employees. Why? Because many younger or lower wage and income employees cannot afford to make regular payroll deferrals to a 401k. What’s more, many others simply choose not to. In fact, only two-thirds to three-quarters of eligible employees elect to defer a portion of their salary to their 401k.

This makes the ESOP both a powerful recruiting tool for employers and a meaningful retirement benefit for the employees—one that the employees pay nothing for!

ESOP vs. 401k: What Does it Mean for the Employee?

When comparing ESOPs vs. 401k plans, it is important to remember that ESOPs, historically, have a higher rate of return, whereas 401ks experience far more volatility due to the frequency of valuations (yearly, for an ESOP) and market fluctuations (daily, for a 401k). Additionally, the yearly valuation of the ESOP is performed by an independent appraiser, adding to its security as an investment vehicle.

The funds invested in an ESOP will grow tax-free until distribution. This provides the employee with the option to rollover these distributions to another retirement plan (including a 401k), thus avoiding capital gains taxes until retirement and adding to the versatility of this retirement tool.

Additionally, with a 401k, employers will usually only match up to 4% of the employee’s own contributions, whereas with an ESOP, the employers traditional contribute what equates to up to 6-8% of the employee’s annual salaries—and at no cost to the employee!

ESOP vs. 401k: For the Business Owner

ESOPs result in both increased employee retention as well as greater employee productivity. Employee ownership can also positively impact the value of the company’s stock, as well as the continued success of the company.

With an ESOP:

  • The business owner can maintain full managerial control until their retirement, without risking any potential damage to the company’s brand due to merger or sale. Ownership can then be passed to its employees when the business owner is ready.
  • An alignment of interest is created between the business owner and the employees, where additional compensation is directly linked to the success of the company. Most often, an ESOP is offered in conjunction with another retirement plan, like a 401k, making the job opportunity that much more attractive.

Thus, it is clear that a 401k cannot compare, since there is no correlation between the employee’s job performance and the benefits that they receive.

So, are ESOPs a viable retirement option? ESOPs create mutual loyalty between the employer and the employee. In that respect, they are indeed viable.

When deciding which retirement vehicle is the best for your employees, it is important to remember that the most valuable assets of your company are the very people that it employs. Therefore, if you chose an ESOP, the employees will likely be far more aligned with your goals because they, too, will directly benefit from the company’s success.

If you have any further questions, feel free to contact us at Aegis Trust Company for a free consultation to see if our ESOP trustee services could be the right fit for your company.

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