So your company offers an ESOP huh? Well, that’s nice, but what even is an ESOP? And what does it mean for your financial plan? We’ll get into more detail later, but for now, I like to think of ESOPs like coffee sweetener to a good cup of retirement plan coffee. While it’s not needed for your retirement plan, it can add a wonderful sugary boost. But you don’t want too much sugar in your coffee, or you’ll get sick. But first, let’s talk about the basics.
ESOP Basics: ESOP stands for employee stock ownership plan. Companies offer ESOPs when they want to:
· provide its employees with a tax-advantaged means to acquire company stock
· instill a sense of ownership in employees
· broaden ownership of their stock
· create a market for its stock
· provide liquidity for shareholders’ estates
· provide for business continuity
By law, ESOPs must primarily invest plan assets in employer stock. But when participants reach age 55 or have ten years of participation, they must be given the right to diversify up to 50% of their account.
Investing in an ESOP, Should I or Shouldn’t I: Most people ask the question, “My company is starting an ESOP, and they are putting some stock into the plan. They’ve given me the option to buy more stock. Should I?” Well, it depends. Here are reasons why you might want to buy more stock:
· You believe in the trajectory of the company.
· You already have a diversified portfolio of investments.
· The ESOP has shown growth consistently over time and your company is stable.
ESOPs can be great, but the key is to make sure that you aren’t investing too much of your retirement savings into ESOPs. This would leave you dangerously undiversified, and your entire retirement savings plan could go down in smoke if the company goes belly up (remember Enron?). A good rule of thumb is roughly 10% of your retirement assets can be invested in an ESOP that you believe in. This provides a good upside potential to sweeten your retirement portfolio if the stock dramatically increases in value, but also limits your losses if the company becomes lukewarm (get it… coffee). Just remember… too much sugar makes your coffee gross, and too much ESOP makes your retirement plan undiversified.
ESOP Taxation: Another question that ESOP participants ask is, “How are ESOPs taxed?” Well, mostly similar to a traditional 401k but with a twist. Stock goes into the account tax-deferred, so no taxes are owed while working. Then the following happens:
· When you separate from the company or reach an age 55, you have the stock distributed to you. This is a taxable event, and you will pay some taxes once this happens.
· The cost basis (the stock’s value when it was put into the account) is taxed as ordinary income… all at once. So, stock with a basis of $30,000 but a market value of $100,000 at time of distribution will incur $30,000 of ordinary income taxes. This is phantom income because you still don’t have the cash. It’s stock.
· To actually get cash, you have to sell the stock. Any gain above the basis is taxed at long-term capital gain rates (woot!) when you sell the stock. This is called Net Unrealized Appreciation (NUA). So, if the stock above grows from $100,000 at distribution to $120,000 in 6 months and then it’s completely sold, there is $90,000 of gain. Note that long-term capital gain always applies here. ESOPs never invoke short-term capital gains rates.
If you have questions about ESOPs, our staff at Independent Financial Planning can help. Feel free to reach out to us at 571-969-1459 or visit our website at ifpinvest.com.
