Photo by American Advisors Group / Flickr
If you read Money Talks News daily, you’re probably comfortable with such terms as 401(k) and IRA. Now it’s time to throw some more letters into the alphabet soup of retirement savings.
It’s time to talk about ESOPs.
These are employee stock ownership plans, and, according to The National Center for Employee Ownership (NCEO), 13.5 million workers participated in one during 2014. If you’re one of those people or if you’ve heard talk about your company starting an ESOP, here’s what you need to know.
How ESOPs work
An ESOP shouldn’t be confused with a stock option plan. Stock option plans typically allow workers to buy existing or future company stock at a set price, and these programs are responsible for many of the rags-to-riches stories you hear coming out of Silicon Valley.
ESOPs work slightly differently. Instead of giving employees the opportunity to buy stock, they automatically assign ownership shares to eligible workers.
It works like this: A business creates a trust fund that holds company shares or money to buy company shares. The value of the shares is determined by an independent appraiser. Then the shares are divvied up among workers. The NCEO says most companies with these plans offer shares to all full-time workers older than 21.
How those shares are divided can vary by company, but in most cases, workers earning more and with greater seniority get a greater portion of the shares. In addition, it may take anywhere from three to six years to be vested in the plan. In other words, you need to work at a company for a certain number of years before you can walk away from an ESOP with any cash.
Benefits for workers
And, from a worker’s perspective, walking away with cash is the main benefit of an ESOP.
While employed, a worker doesn’t actually hold any shares of the company. They are kept in the trust fund and only disbursed once a vested employee is terminated, retired, disabled or otherwise leaves the company.
At that point, the ESOP has an obligation to buy back the employee’s shares. The NCEO says only 3 percent of ESOPs are with public companies, that is, those with stocks being traded on a stock exchange. For those companies, the value of an employee’s shares will be determined by its market value (i.e., the current stock market price). All others get a payout based upon an independent appraisal of the stock’s worth.
In 2010, the NCEO analyzed 2008 data and found the average ESOP participant got $4,443 each year in company stock contributions. The average account balance was $55,836.
When workers walk away with that money, they may either pay regular income taxes on it or, if certain requirements are met, the capital gains tax. Depending on their tax bracket, the capital gains tax could be significantly lower.
Another option is to roll over the ESOP payout into an IRA and avoid any immediate taxation.
Why businesses set up ESOPs
For workers, there is nothing not to love about an ESOP. They usually require no buy-in from employees. You simply show up to work and, after a few years, earn the right to walk away from your job with extra cash in your pocket.
But what’s in it for businesses?
Certainly, ESOPs are not cheap to set up. The NCEO estimates the most basic plans can cost a company upward of $40,000 to implement. However, there are several business benefits that could make that price worthwhile.
The ESOP Association says there are two main reasons a company might set up an employee stock ownership plan.
- Buy out a retiring owner. In some cases, an ESOP is created when the owner or founder of a closely held company is ready to retire. This option eliminates the need for the owner to find a buyer for the business and helps ensure the continuity of the company.
- Provide an employee benefit. The other reason companies create an ESOP is simply to provide a benefit for employees, one that may also provide an incentive for workers to be more productive and loyal.
To that second point, there is evidence an ESOP may in fact encourage worker loyalty. The ESOP Association says 2010 data found that only 13 percent of workers participating in an employee stock ownership plan expected to leave their company in the coming months, compared with 24 percent of workers at non-ESOP companies.
Beyond employee benefits and owner buyouts, ESOPs offer companies certain tax benefits. For example, its contributions to the trust fund can be tax-deductible, as can dividends.