The ESOP Participant's Guide to ESOP Distribution Rules
When Will You Get a Distribution?When you will get a distribution of your vested ESOP account balance depends on the rules the company sets up. You can find these in your plan Summary Plan Description. If you do not have a copy, request one from your plan administrator. The rules must fit within the requirements of the law.
If the value of your ESOP account balance exceeds $5,000, your company cannot force you to take a distribution until you reach normal retirement age; in other words, you have to consent to a distribution as opposed to choosing to leave your assets in the plan. If you have not retired, distributions must begin in any event on April 1 of the first year after you reach age 70½. It is rarely a good idea to leave the account in the ESOP, especially if it is in company stock. If you want the assets still to be in a retirement plan, roll them into an IRA (there is no tax on doing this), where you can then reinvest them as you see fit.
In what follows, we talk about the "plan year." That means the annual accounting period for the ESOP. It may be the same as the company's "fiscal year," the accounting period for its income statement and balance sheet, but it does not have to be. Your plan year may be from January 1 to December 31, for instance, or July 1 to June 30 or some other 12-month period.
By law, the company can distribute your account balance not later than a specified time after you leave, depending on how old you are and whether you die or are disabled, as described below. Note that some plans provide for earlier distribution.
If You Leave Before Normal Retirement Age: Distribution must start within six years after the plan year of when you terminate employment, unless you elect otherwise. Companies can pay you out in installments at that point over five years, with interest. The Summary Plan Description will tell you what is considered normal retirement age. In many companies, it is 65, but it could be earlier. It cannot be later than 65 or, if later, when you have five years of participation in the plan and are over 65.
Death, Retirement, or Disability: If you leave because of death, retirement, or disability, or reach normal retirement age after you terminate employment but before an ESOP payout has started, distribution must start during the plan year following the plan year in which the event occurs (so up to two years after you leave), unless the you elect otherwise.
Exceptions: If the ESOP has borrowed money to buy stock and has not completed repaying the loan, distributions to terminating employees do not have to start until the plan year after the plan year in which the loan is repaid.
There are also certain complex exceptions if you have retired or die. For shares on which the loan has not yet been repaid, for death, distribution does not have to start right away, but must be completed by the end of the calendar year of the fifth anniversary after death and made to the beneficiary, regardless of the loan status. For retirement, for people who are not 5% or more owners of the company, distribution must start no later than the 60th day after the end of the plan year in which the later of these events occur: (1) the participant reaches age 65 or, if earlier, the plan's normal retirement age, (2) the employee reaches age 70 1/2 and is a 5% or more owner, (3) the calendar year in which the employee retires, or (4) the 10th anniversary of participation in the plan.
This means that employees who reach age 65 prior to 10 years from the anniversary date of their original participation in the plan (note this is not 10 years' employment, but 10 years from the start of participation in the ESOP) could have to wait until the 10th anniversary occurs to become eligible. Plan participation would include years in a predecessor defined contribution plan if it were not terminated, but rather were folded into the ESOP. The interaction of this rule with installment distributions is complex and beyond what most people need to be concerned about.
VestingHow much you will get distributed to you depends on two things: how much is in your account and how vested you are in that account. Vesting is the process by which you accumulate a right to your account. By law, you must be 100% vested based on one of two schedules:
- No vesting at all in the first years, followed by a sudden 100% vesting after not more than three years of service ("cliff" vesting); or
- Twenty percent vesting after the second year of service, with 20% more each year until 100% vesting occurs after the sixth year of service ("graded" vesting).
If the plan is terminated, however, all participants become 100% vested.
What Happens If Your Company Is Sold?In some case, your company may be sold to another ESOP company. Usually, you would then have your ESOP shares rolled over into the shares of the new company ESOP. In other cases, the acquiring company will cash out your shares and roll the proceeds into an account in your name in their 401(k) plan. Finally, the company may purchase your shares and give you the cash (see the section below on taxes on how this is taxed).
Understand, however, that many acquisitions take time. Even after your company has been purchased, funds in the ESOP may be held in an escrow account (a special account to set aside funds) until all remaining issues in the sale are completed, such as resolving any liabilities the company may have or satisfying certain conditions for the sale. It is uncommon, but not unheard of, for a sale to be undone if these issues are not resolved, so the money is held in escrow until they are.
How Do You Know What You Have?By law, your company must send you an annual account statement telling you how much is in your ESOP in cash and in stock. The stock price is determined by an independent outside appraisal firm. If you do not receive a statement, contact the company's human resources or payroll department and request a copy.
What Form Will Your Distribution Take?The company can make your distribution in stock, cash, or both. Many ESOP participants leave with an account that has both stock and cash in it. The cash will be paid out in cash. The share portion may be cashed in, so you will get cash for the shares as well. The company might also choose to give you the shares, which you then have 60 days to sell back to the company at the appraised fair market value. If you think the value will go up, you can wait one year and have another 60-day period (but there is no further right to sell after this).
The payment may be in a lump sum, meaning you get it all at once, or in installments, meaning you get it over time. If you get shares in installments, you get a portion of what is due to you each year in stock. The value of the shares will change from year to year.
If you leave and do not get a distribution right away, you account balance can be held in stock (meaning the value will change each year), cash, or some of both.
Diversification Rights Before Leaving the CompanyAs an ESOP participant, you have the right to diversify part of your ESOP account balance once you have 10 years or more of participation in the plan (defined as the ESOP or a predecessor plan whose assets were transferred to the ESOP) and are 55 years or older. You can diversify up to 25% of the shares in your ESOP account at age 55 and each year thereafter and 50% at age 60. This is cumulative; an employee diversifying 25% at age 55 cannot diversify 50% of the remainder at 60.
What if you do not accumulate 10 years of participation until after you reach age 55? In that case, your right to diversify 25% starts when you do and continues for another five years, even though you would be older than 60 then. For instance, if you have 10 years in the ESOP as of age 57, then you would be able to diversify 25% at age 57, have five more chances to keep up to 25% of whatever shares are in your account diversified until you were 62, and then could have up to 50% diversified.
Some companies will pay you out directly by buying your shares for fair market value. Others will put the cash into a 401(k) account and allow you to direct its investment.
Getting Money Out of the ESOP Before Leaving the CompanyAlthough an ESOP is mainly designed to provide benefits after leaving employment, there are certain circumstances in which you might receive money before leaving the company:
Diversification: As noted above, one diversification method involves the company paying you directly.
Borrowing: One way to get money out of a retirement plan would be to borrow funds from it and pay them back. But almost no ESOPs allow this (some 401(k) plans do). The reason is that if you borrow money out of your account and the stock value then falls, the company has no collateral to get the money back if you decide not to repay the loan.
In-Service Distributions: A small number of ESOPs and other retirement plans allow for what is called "in-service" distributions where some of the employee's account balance is paid out periodically while people are still employed, but very few ESOPs do. If a company has such a plan, it has to be offered on the same basis to everyone. It cannot take a request from one individual and honor just that.
In addition, if your company is a C corporation, it may choose to pay dividends directly to ESOP participants on the company stock in the ESOP. This is not a distribution of your account balance, however, but rather a payment of earnings on the stock.
Tax IssuesIf you put the money into a traditional (not Roth) IRA or the distribution is rolled forward into another qualified retirement plan in another company, there is no tax until the money is withdrawn, when the withdrawal is taxed as ordinary income (that is, like any other income you get other than capital gains). Otherwise, you must pay ordinary income tax on the value of company contributions to the plan, capital gains taxes (generally much lower) on the appreciation in share value when sold, and a 10% penalty if the distribution is not after age 59 1/2 or for death, termination after age 55, or disability. Note, however, that some installment distributions will not qualify for either the roll-over into an IRS or capital gains treatment. Few participants will face this issue, but your company should let you know if you do.
The rollover to an IRA or another qualified plan is normally done as a direct rollover, meaning the employee notifies the company that the allocation should be rolled over into the successor plan before the allocation is paid out. Alternatively, the amount can be paid out to you, and you then have 60 days to roll it into an IRA.
Amounts rolled over into a Roth IRA are taxable, but are tax-free when withdrawn if that is done according to the Roth IRA rules.