When Will I Be Paid? The ESOP Participant's Guide to ESOP Distribution RulesUnderstanding what is in your ESOP account and what the rules are for when and how you will get it can seem complicated. While there are general rules all ESOPs must follow, plans do vary from company to company. 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. To find out what your plan's rules are, read the Summary Plan Description your company provides you. If you do not have one, ask your human resources department for another copy.
When Will You Get a Distribution After Leaving Employment?For the most part, you receive ESOP benefits after leaving employment. The basic ESOP rules are as follows. The "plan year" is the ESOP's annual reporting period, which may follow the calendar year or be something different like July 1 to June 30. The plan's "normal retirement age" cannot be later than 65 or, if later, the fifth anniversary of plan participation.
- If you leave because you reached the plan's normal retirement age, become disabled, or die, distributions must begin during the next plan year. This means your distribution could start very soon after you leave or as long as almost two years, depending on the timing.
- If you leave for some other reason (such as quitting or being terminated), distributions must begin no later than six years after the plan year in which you left.
- The ESOP loan exception, available in C corporations and, according to some interpretations, in S corporations: In both cases above, if you have shares in your account that were bought by a loan the ESOP took out that is still being paid for, the start of distributions on those shares may be delayed until the plan year after the loan is fully repaid. But these distributions must be completed by the later of the plan year after the loan is fully repaid or the date they otherwise would have been completed.
Examples of the ESOP Rules
- You retire at age 65, the plan's retirement age, in 2022 and the plan year ends December 31. The plan must start distributions to you by sometime in 2023. They must be completed no later than 2028.
- You quit in 2022 at age 40 and the plan year ends December 31. The plan could require that you wait as long as until 2028 before starting distributions. They must be completed no later than 2033.
- An ESOP loan exception example: You quit in 2022 at age 40 as in the above example, but all of the shares in your account were bought by the ESOP with a loan it finishes repaying in 2033. In this case, under the ESOP loan exception, the commencement of distributions can be delayed until 2034, the year after the loan was repaid. However, they cannot be stretched out over five years the way ESOP distributions usually can; here, they must be completed in 2034, which is the later of the year after the loan was repaid (2034) and the year your distributions would be completed absent the ESOP loan exception (2033).
The General Retirement Plan Rules May Override the ESOP Rules AboveWhat may be called the "general retirement plan rules" are rules that cover all retirement plans that can, in a few cases, override special rules for ESOP. If the general retirement plan rules below would require an earlier distribution, they override the ESOP rules.
- Distributions 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 participant's employment terminates; or (3) the participant reaches the 10th anniversary of participating in the plan.
- If you reach age 70½ and are still in the plan, distributions must begin no later than April 1 of the next calendar year if you are a more-than-5% owner of the company; otherwise, they must start no later than April 1 of the first calendar year after you retire.
- There are special rules for distributions after death, which are too complicated to discuss here.
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 generally 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).
A year of service means working 1,000 or more hours in a plan year. Some companies count years of service prior to the ESOP being started, some do not. Also, there are some additional rules for some ESOPs that have borrowed money in 2006 or earlier that could allow them to delay cliff vesting until after five years of service and graded vesting until the completion of the seventh year.
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 IssuesDistributions are usually taxed as ordinary income, but if you receive a lump-sum distribution of your account and it is in the form of shares (not cash), you will (unless you otherwise elect) pay ordinary income tax on the value of company contributions to the plan, and then capital gains taxes (generally much lower) on the appreciation in share value when the shares are sold. There is a 10% penalty tax if the distribution is not after age 59 1/2 or for death, termination after age 55, or disability.
If 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). 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. Some installment distributions will not qualify for a rollover into an IRA.
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.