One of the biggest advantages to employees who participate in an Employee-Stock Ownership Plan (ESOP) is the retirement benefits received. Receiving those benefits is considered an ESOP distribution. There are several ESOP payout rules that must be followed in order for retired, terminated, or exited employees to receive their benefits and final distribution could take years. In this post, we share answers to some of the most common questions surrounding ESOP distributions.
ESOP Distribution Definition
An ESOP distribution is simply the payout of benefits to qualified participants. Participants may qualify for a distribution in several ways:
- They are retired from the company and are over age 59.5.
- They have been terminated by the company or quit and are over age 55.
- They are still working for the company but are over age 70 ½.
There are two situations that may qualify a participant for "in-service" distributions. An in-service distribution occurs when the participant is still working for the company. Participants may qualify for an in-service distribution if they qualify for a "hardship" distribution or if they are over 55, have been in the plan for more than 10 years, and qualify for a diversification distribution.
How Does an ESOP Distribution Work?
ESOP distributions are governed by the IRS. This means they must follow specific guidelines and meet certain criteria. All ESOPs must have a distribution policy which can be found in the plan document or in a separate document specific to distribution. This document will contain information about payout options, lump sum thresholds, installment payments, and vesting requirements. Companies decide how to make the distribution: in shares, cash, or both.
In order to receive your distribution, you will need to be vested. If you are not vested and quit, for example, you may not ever qualify for distribution. If you are vested, you will need to request the distribution forms from the ESOP company. You may receive these forms as part of your retirement or exit paperwork. You may receive your distribution in installments or as a lump sum, depending on the plan's distribution policy. Benefits are typically distributed as company stock or in cash based on the current stock price.
How Long Does it Take to Receive an ESOP Distribution After Leaving Employment?
When you receive your ESOP distribution depends on the manner in which you left employment. ESOPs are required to distribute payouts no later than a certain time after an employee leaves the company. Distribution begins:
- One year after the close of the plan year in which a participant leaves the company due to retirement, disability, or death.
- No later than six years after quitting or being terminated by the company.
- A plan year refers to the ESOP's annual reporting period. This may or may not follow the calendar year. Due to this timing requirement, your distribution could begin soon after you retire or close to two years afterward. For those who leave or are fired, it may take as long as 11 years to receive the full distribution payout.
- The normal retirement age for ESOPs is set at 65.
- If the ESOP is leveraged, your shares may not be available until the loan is paid in full.
What Happens to Your ESOP Distribution if Your Company is Sold?
When a company that has an ESOP is sold, all employees are immediately vested and eligible for distribution. How those assets are distributed depends on how the business was sold.
- If the business is sold to another ESOP, existing shares are typically rolled over into the new company's shares.
- If the company is sold to a non-ESOP company, the buyer will likely cash out your shares and roll the proceeds into the new company's 401(k).
- The purchasing company may purchase the shares at fair market value and pay you a cash lump sum.
How Are ESOP Payouts Made to an Employee and When?
Distributions are either made in a lump sum or in equal payments spread out over a period of five years for retirees. In some cases, distribution may be spread out over ten years if the account balance exceeds a specified amount. This threshold amount is set each year by the IRS.
If you quit or were terminated by the company, you may receive your distributions as one lump sum or spread out over six equal payments over five years once you qualify for distribution.
If you receive your payout in installments, the value of the stock will likely change from year to year, which could see your payout amount increase or decrease depending on the stock's value in the year it was distributed.
How are ESOP Distributions Taxed?
Since ESOP shares are not taxed until the time of distribution, there are tax considerations to keep in mind when taking your ESOP distribution. Your tax obligation is dependent on your age and financial situation.
In general, ESOP distributions are taxed as regular income, but if you are under 59 ½ distribution counts as an early withdrawal. Early withdrawals are subject to an additional 10-percent tax on top of your regular income tax rate. In order to avoid this tax penalty, many participants roll their ESOP shares into a different retirement account like a traditional IRA or a Roth conversion.
If your distribution takes the form of a lump-sum distribution in shares it will be taxed as regular income and you will need to pay capital gains tax on the appreciation in share value when you sell your shares.
One more area of taxation applies to participants who continue to work past retirement age. ESOP participants who are 70 ½ years of age or older are required to take the minimum required distributions (RMDs), even if they are still working. If they fail to do so, they face a 50-percent tax penalty on the amount not taken.
Many participants choose to roll their distributions into a traditional IRA, Roth conversion, or another qualified retirement plan in order to defer taxation until they withdraw the funds. When the funds are withdrawn, they are typically taxed as regular income. Recipients typically have 60 days to complete the ESOP rollover into an IRA.
Who can help me with my ESOP Distribution?
If you qualify for an ESOP distribution or want to learn more about how an ESOP distribution will affect your retirement plan and tax burden, you should consult your financial advisor, accountant, or a CPA. In the meantime, reach out to your HR or Benefits department to obtain the ESOP plan documents and distribution instructions.
As an ESOP trustee, Aegis Trust Company does not assist plan participants with their distributions. If you're an ESOP company or considering an ESOP for your company, reach out to us to learn more about our ESOP Trustee Services.
The National Center for Employee Ownership (NCEO) has an excellent resource available on their website for download. The Participant's Guide to ESOP Distributions can help you better understand the ins and outs of ESOP distributions.