Owners' Page: Diversifying Shares: Your Questions Answered
When Can I Diversify the Shares in My ESOP Account?
Owning stock in an ESOP can be a great thing, but as employees get closer to retirement, it is often advisable to diversify what is in your ESOP, especially if the ESOP stock is a high percentage of the total retirement assets you have.
The law governing ESOPs requires that companies allow you to do this. This article answers some key questions.
When Do I Become Eligible?
You can diversify up to 25% of the company stock in your account once you reach both age 55 and have 10 years of plan participation. You may have worked for the company for more than 10 years, but what counts is only the years you have been in the ESOP. Some companies have more liberal rules than this. If in the first year you diversify all 25%, then in each of the following five years you can still diversify, but only 25% of the shares just added to your account in the prior year.
At the end of five years, you can diversify up to 50% of all the shares that have been in your account, so that half your account balance is in company stock. The other half will either now be in your 401(k) plan, paid out to you in cash, or still in the ESOP but invested in other things. Generally, if it is still in the ESOP, the company has to give you at least three different investment options.
If you take the money in cash, you will have to pay taxes on the amount, and if you take it out before age 59 1/2, there is also a 10% penalty tax because the government wants you to save this money for retirement.
What If I Don’t Have 10 Years in the Plan Until After I Am 55?
In this case, the first year of diversification is when you reach 10 years of participation in the plan. You then have five more years to diversify 25% of the shares that are added plus another 25% after the fifth year.
What If I Do Not Diversify All I Am Eligible to Diversify?
Say you only diversify 15% in the first year. You can still choose in each of the next five years to get up to 25% total. But once the last election allowing you to get to 50% occurs, you cannot choose to diversify any more.
What If I Leave the Company? Can I Still Diversify?
There are no firm rules on whether former employees are subject to diversification rules. Your company’s plan should state the rules on this, however. The IRS seems to be willing to accept an interpretation that former employees are not eligible, but many companies do make them eligible. If that is what your plan says, you could count your years of service including after you leave (but are still in the plan).
How Much Time Do I Have to Decide?
The company will send out a notice to you when you are eligible. The annual election period usually starts at the end of the plan year and ends 30 days after the updated share value and eligible diversification amounts have been communicated to participants who are eligible to diversify. Then there is a 90-day period for processing your diversification election that begins the day after the close of the election period.
Some companies use a different approach to this, such as giving people 90 days as soon as they are eligible based on a prior valuation, but then letting them revoke their choice when the new valuation is updated. Your company will let you know what rules it uses.
Should I Diversify?
Many ESOP participants make their choice based on what has been happening to the share price. If it has been going up faster than their other investments, they stay in company stock; if not, they are more likely to diversify.
This is usually not a good way to make the decision. Stock prices often do not just keep going in the same direction, and past performance may not be a good predictor of the future.
Another way to decide is to look at how much of your total assets (401(k), IRA, or non-retirement savings) are in company stock. Investment advisors often recommend that not more than 10% be in any investment to assure adequate diversification. That is a very conservative point of view, and if you are risk-averse, a good one.
A third way that may make the most sense is to think about your retirement critical number. This is how much money you need in retirement savings so that the income from that, plus income from Social Security (you can find out what this will be by setting up an account on the Social Security website) and any other sources (work, rental property, etc.) you and your spouse or partner will have will be enough to meet your anticipated needs, plus a cushion for emergencies, long-term health care, and/or things you really want to do (travel, for instance). Figure you can take about 4% per year from your retirement income (advisors vary on what this number should be).
Once you know that, then you can more easily decide how much of your account in the ESOP you want to risk. If you are uncertain, hiring a financial advisor can help.