An Employee Stock Ownership Plan (ESOP) is a defined contribution retirement plan that primarily invests in employer stock. Created by the 1974 Employee Retirement Income Security Act (ERISA), ESOPs essentially give employees an ownership interest in their company. While these plans offer many advantages, understanding the tax implications of distributions is essential for effective retirement and tax planning. Many factors impact ESOP tax treatment, including your age at distribution, rollover options, how you’re paid at distribution, and whether you use any strategies to minimize your tax burden.
What Is an ESOP Distribution?
An ESOP distribution is a payout of your ESOP plan retirement benefits after retirement, departure from the company, disability, death, or certain other qualifying events as the plan allows.
Federal tax law sets limits on distribution timing while the plan document provides the key details such as whether there is a mandatory waiting period after retirement or separation, how withholding is handled, and whether distributions are paid annually, in installments, or as a lump sum.
Required Minimum Distributions (RMDs) also play a role. You must begin taking your RMDs at age 73, or 75 if you were born in 1960 or later.
The Importance of Vesting
ESOP distributions are subject to vesting, meaning participants need to meet a minimum time period worked for the company to be fully vested. Depending on the company’s vesting policy, you may forfeit your benefits if you are terminated before becoming fully vested. Some plans use cliff vesting and you become fully vested after a minimum period, while other plans vest by a set percentage each year you work until reaching 100% vesting.
How Are ESOP Distributions Paid?
ESOP distributions can be made in stock, cash, or both. They may also happen through lump-sum payments or installment payments of up to five years. For large balances, the installment payment period can be extended to up to 10 years. The amount of the distribution is based on three factors: 1) The number of shares you have, 2) the value of the shares, and 3) whether you are fully or partially vested in your employee stock ownership plan program.
If the company pays in cash, it typically repurchases the shares at market value and distributes the cash amount. If a private company pays in stock, the participant receives a put option to sell the shares back to the company during two separate windows. The first window is at least 60 days after the distribution. If you don't exercise the put option then, you can exercise it during a second window of at least 60 days after the next valuation in the following plan year. Using the second window may be beneficial if you expect the share value to rise. Once both windows close, the option expires.
Unlike an IRA, where retirees may choose to take monthly withdrawals to help simulate a paycheck, ESOP distributions are often more limited by the plan’s terms. Some plans may only allow distributions annually, while others may provide lump-sum or installment options.
How Are ESOP Distributions Taxed?
Are ESOP distributions taxable? The answer is yes. Most ESOP distributions are taxed as ordinary income and are generally taxable in the year they are received.
Understanding the potential tax on an ESOP distribution starts with how the benefit is paid. Taxes are typically due only when distributions are paid out, making it important for individuals to consider how those withdrawals may affect your taxable income during retirement.
Depending on your distribution options, you may be able to defer ESOP distribution taxes by rolling eligible distributions into an IRA or another qualified retirement plan. Careful planning can also help you manage your annual income and avoid being pushed into a higher tax bracket.
In many cases, you will pay ordinary income tax on the value of the cash or stock that is distributed. If you receive company stock as part of your distribution and later sell those shares, any appreciation in value after the distribution may be subject to capital gains tax.
It's also important to understand the rules surrounding early withdrawals. Distributions taken before age 59½ may be subject to a 10% early withdrawal penalty in addition to ordinary income taxes, although certain exceptions may apply. Distributions made after a participant's death or due to a qualifying disability generally are not subject to the penalty, though beneficiaries may still owe income tax on amounts they receive.
The major exception to the 10% penalty is the age 55 exception, where taxpayers who separate from the company during or after the year they turn 55 generally avoid the 10% penalty.
State tax treatment can vary. While many states generally follow federal tax rules for ESOP distributions, some have unique provisions that may affect the taxation of retirement plan distributions, particularly for S-Corporation ESOPs. Because these rules can be complex and differ by state, it is important to consult a qualified tax advisor to understand the potential tax implications in your situation.
Figuring out ESOP distributions and taxes can be daunting. Planning ahead can help you maximize the value of your ESOP benefits while minimizing unexpected tax consequences, allowing your retirement and wealth transfer strategies to work together more effectively.
Receiving Company Stock vs. Cash
ESOP taxability can depend on several factors, including whether you receive cash or company stock.
Cash distributions are taxed as ordinary income when distributed. However, if you instead receive a lump-sum distribution of company stock and don't roll it over, you generally pay ordinary income tax only on the plan's cost basis. The appreciation of the shares while held in the plan, called net unrealized appreciation (NUA), isn't taxed until you sell the shares. Understanding Net Unrealized Appreciation (NUA)
Net unrealized appreciation allows you to pay ordinary income tax only on the stock’s original cost basis when it was distributed. The growth while the plan held the shares is taxed at long-term capital gains rates when you sell, no matter how long you hold the shares afterward, which lowers the tax burden. Any growth after the distribution is taxed as long-term or short-term gain, depending on how long you hold the shares after you receive them. However, the ESOP plan may limit the ability to take the distribution in stock or have complicated rules or processes to do so.
Also, with NUA, the distribution is a lump sum. Keep in mind that rolling the stock into an IRA forfeits NUA treatment, so the full value will be taxed as ordinary income when you eventually withdraw it from the IRA.
A key consideration with NUA is whether the ESOP has a forced sale-back provision. For example, Taxpayer A receives company stock with a fair market value of $1.25 million and a cost basis of $250,000. Under an NUA strategy, Taxpayer A would generally pay ordinary income tax on the $250,000 cost basis. However, if the plan requires the stock to be sold back immediately, the taxpayer loses the ability to defer the capital gain until a later sale. Since the proceeds are also no longer in a retirement account, any future growth is taxable.
ESOP Rollover Into IRA
Rolling your distribution into a qualified retirement account may let you avoid immediate taxes. A direct rollover also sidesteps the mandatory 20% federal income tax withholding. If an eligible rollover distribution is paid to you instead, that withholding generally applies to the taxable amount, even if you roll it over later.
First, confirm you're eligible for a rollover, then choose between a traditional or Roth IRA. For a direct rollover, ask the plan to transfer the funds straight into a qualifying retirement account. This lets you skip the immediate tax on the distribution, keep saving for retirement, and diversify your investments. A rollover into a Roth IRA is a taxable conversion in the year of the rollover, but future qualified withdrawals are tax-free.
If you choose to do an indirect rollover, you have 60 days to complete it or risk a tax penalty and the loss of your tax deferment.
Common ESOP Distribution Tax Mistakes to Avoid
Working with an advisor can help you avoid common ESOP distribution pitfalls, such as:
- Taking a lump-sum distribution without considering tax consequences
- Missing rollover deadlines
- Overlooking Net Unrealized Appreciation (NUA) opportunities
- Failing to account for state taxes
- Ignoring required withholding and estimated tax payments
The many nuances mean it’s essential to look at all your options before taking a distribution. An experienced tax advisor and help you figure out the best ESOP tax planning strategies for you.
This content is for general informational purposes only and does not constitute tax, legal, or professional advice. Readers should consult their tax advisor regarding their specific situation before making any tax-related decisions.