How does an ESOP work? How does it work with a 401k plan?

An ESOP is an Employee Stock Ownership Plan. It is an ERISA-governed employee benefit plan that allows the employee to purchase shares of the employer’s stock on a tax deferred-basis. (You don’t pay taxes today but you will pay taxes when you take your money out of the plan.) ESOPs were common before the rise of 401k plans in the 1980s. Today it is common for employers to offer company stock in their 401k plans. The company stock in the 401k plan is often an ESOP within the 401k in a structure sometimes called KSOP. (For more information about KSOP plans you can read my 2010 article on why KSOP plans are bad.) Before investing in an ESOP or your 401k you should understand how these work and the risks involved.

Fort Worth employment lawyers on ESOP background

If your employer offers an ESOP within your 401k, it will look like any other investment option in your 401k except unlike the mutual funds that likely make up the majority of your 401k investment options, the company stock option is not diversified. It is usually 100% company stock. (Or almost 100% company stock with a small amount of cash to allow it to execute its transactions.) Employers used to be able to require matching contributions to the 401k go to company stock until the employee retired.

As a result of the Enron disaster in 2001, where 60% of the 401k assets of the company’s employees were tied up in the company stock and was wiped out when the stock collapsed, Congress included a provision in the Pension Protection Act of 2006 that once an employee has three years of service with the employer they may take the matching contributions out of the company stock and shift it to other investments.

Your Dallas or Fort Worth employer may offer a standalone ESOP. These plans are less common now because it is easier to manage them through the 401k as a single plan. The majority of standalone ESOPs are in the hands of small, private companies.

Dallas employment lawyer on ESOP dividends

One curiously unique quirk about ESOP plans is that dividends or stock distributions from the stock within the plan can pay out to the plan participants without the 10% early distribution. In 401k and ESOP plans, if you voluntarily withdraw funds before age 59 ½ (unless you meet a very small set of exceptions) you owe income tax plus a 10% penalty on the money you take out. ESOP dividends are subject to income tax but not the penalty.

Participants in the ESOP may elect to take the dividends or stock distributions as direct payments and receive the money right away or reinvest in the plan. In a non-company stock investment, whether it is in a 401k or non-company stock investment in the ESOP, the participant generally does not have the option to take dividends or other investment distributions from the plan when they are paid by the investment and if they do take the money out, the early distribution penalty rules are applied.

If your employer offers an ESOP or company stock within your 401k, it is an individual decision whether investing in it is the right decision for you. The benefits of the plan, the viability of the employer, your tax situation, your financial situation and your financial planning are just some of the key considerations you should employ. You should talk to your tax advisor and a financial advisor to determine the best course of action in your case.

Common mistakes investing in ESOPs

One common mistake people make is to look at that opportunity to invest in the company without considering the consequences. In my experience dealing with retirement plans from both the plan administration side and helping employee participants with their rights under these plans, I can safely say ESOPs are almost always structured in a way that benefits the employer (and/or its owners) greatly with minimal risk but offers the employees a lot of risk and substantially less benefit. Without getting into the technical rules around ESOPs, one often overlooked concern is concentration of financial risk.

Employees tend to have very positive pictures of the financial health of their Fort Worth or Dallas employers.  Naturally they want their employers to succeed. As a result, they tend to invest heavily in the company stock as a “sure thing”. I discussed this phenomenon in my 2010 article published in the National Law Review but many other, far more qualified experts suggest the same conclusion. The result of employees heavily investing in their employer’s stock is, as I mentioned before, is concentrating their financial risk.

As an employee, your financial well-being relates to your employer in many ways. You rely on your employer to continue to supply you a paycheck in exchange for your work. You likely rely on your employer’s health care plan to provide your family health insurance. If you have a pension plan, you also rely on your employer for that retirement income. If you have a 401k, you probably rely on matching contributions, further relying on your employer’s well-being. Also, if you have stock options or grants from your employer, that’s more financial risk on your employer’s future. That is already a lot of financial risk in your employer.

Risks of overinvesting in your employer’s stock

When you put a significant portion of retirement savings in your employer’s stock, you put your eggs in their basket. You might benefit from doubling down on your employer’s financial well-being and success; however, if your employer takes a tumble you could lose income, health care and retirement savings all at once. That is making a huge bet on one company. It’s very dangerous. Financial experts suggest you can eliminate up to 70% of your retirement savings risk by diversifying away from your employer. However, you should make your investment decisions with the benefit of tax and financial advice specific to your individual situation.

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