ESOP benefits for employees.

An Employee Stock Ownership Plan (ESOP) can help business owners meet important long-term goals, including succession planning and preserving a company’s independence. But the employees of a company can also benefit from an ESOP in several key ways — from building wealth through company ownership, to gaining a greater stake in an organization’s success.

What is an ESOP and how does it work for employees?

An ESOP is a qualified retirement benefit plan designed to invest primarily in company stock, allowing employees to become owners while building retirement savings. Each year, the company contributes stock or cash to the ESOP trust, which holds the shares. These contributions are allocated to individual employee accounts, typically as a percentage of each participant’s annual compensation. Allocations are often based in part on compensation, so employees with higher eligible compensation may receive larger allocations. Eligibility requirements vary by plan, but employees generally must meet minimum age and service requirements established under the plan document. Many ESOPs require employees to be at least age 21 and complete a specified period of service, often including 1,000 hours during a plan year.

In most cases, employees cannot receive distributions from their ESOP account while they remain employed. The value in their ESOP account is generally paid out in stock or cash when they retire, become disabled or otherwise leave the company. At that point, if private company stock is distributed, the company must offer to buy the shares back at independently appraised fair market value.

Core financial benefits of an ESOP for employees.

For employees, there are several financial advantages to participating in an ESOP:

Greater retirement savings potential.

Research from the National Center for Employee Ownership (NCEO) opens in a new window reveals that employees at ESOP companies have more than double the retirement savings of workers at comparable non-ESOP companies.

Account growth tied to company performance.

Because ESOP accounts hold company stock, their value may increase as the company’s value grows. An employee who stays at a growing company for many years can see potential increases in account value over time.

Tax advantages.

Employees generally don’t pay federal income tax on the value of employer stock allocated to their ESOP accounts while the funds remain in the plan. Taxes are generally deferred until a taxable distribution is received.

Potential diversification rights beginning at age 55.

Participants who reach age 55 and have at least 10 years of participation generally receive a six-year period during which they may diversify qualifying employer stock holdings. During the first five years, they may generally diversify up to 25% of qualifying shares; in the sixth year, the limit generally increases to 50%. This gives longer-tenured employees a way to reduce concentration risk as their retirement date approaches.

Job stability considerations in ESOP companies.

Employee ownership can also be associated with greater job stability. Some studies have found that ESOP companies may be less likely to lay off employees than traditionally owned businesses, even during periods of economic uncertainty. During the COVID-19 pandemic, for example, employee-owned companies retained workers at significantly higher rates than comparable non-ESOP businesses opens in a new window, demonstrating the resilience that often comes with an ownership culture.

One possible reason for this greater stability is that employee ownership can align employees and company leadership around long-term business performance. That shared interest may encourage employees and leaders to work together to find solutions during challenging times instead of relying on layoffs as a first response. In addition, employee-owned companies often take a longer-term view of business decisions, which means they may be better positioned to weather economic ups and downs while preserving jobs.

How ESOPs can support employee engagement and workplace culture.

In many cases, ESOPs can influence how an employee thinks about their work. When employees have a financial stake in a company’s success, they tend to approach their work with a different level of investment — monitoring for inefficiencies, generating ideas for improvement and caring about outcomes that go beyond their individual job descriptions.

Research shows that employees in ESOP companies report higher job satisfaction, stronger workplace relationships and a greater sense of purpose compared with those in traditional firms. The NCEO describes this dynamic as an “ownership culture opens in a new window,” where employees begin to think and act more like owners. Because ESOP shares are tied to company performance, employees have a direct financial interest in long-term success, reinforcing day-to-day engagement in ways traditional compensation structures often do not.

Understanding ESOP vesting and distribution.

Vesting is the process by which employees earn the right to keep the shares in their ESOP account. Shares may be allocated to an employee’s account each year, but employees do not have a nonforfeitable right to those shares until they vest. If an employee leaves before becoming fully vested, the employee generally forfeits the unvested portion of the account, subject to the plan’s terms and applicable rules.

While a company may choose to be more generous, federal rules generally require ESOPs to satisfy minimum vesting requirements, often through either a cliff or graded vesting schedule.

• Cliff vesting: Employees vest 0% for the first two years, and then become 100% vested after completing three years of service.
• Graded vesting: With this schedule, employees vest more gradually. They are 20% vested after year two and are vested an additional 20% each year until they reach 100% by year six.

For many ESOP plans, a year of service is generally based on working at least 1,000 hours during a plan year, although the specific definition is determined by the plan document and applicable rules.

Employees receive their ESOP distribution — the value of their vested account — when they leave the company. The timing of an ESOP distribution depends on the plan’s terms and the reason an employee leaves the company. In some cases, distributions may begin relatively soon after retirement, disability or death. For other types of separation, the plan may delay distributions for several years, subject to applicable legal requirements. Employees should review the plan’s summary plan description to understand when benefits become payable.

Distributions may be paid in cash, company shares or a combination. If shares are distributed, the company must offer to repurchase them at independently appraised fair market value. Employees can typically defer taxation by completing a direct rollover to an eligible IRA or another qualified retirement plan. A 60-day rollover may also be available, although distributions paid directly to the participant can be subject to mandatory federal tax withholding.

Comparing ESOPs with traditional 401(k) plans.

While ESOPs and 401(k) plans are both tax-advantaged retirement accounts, there are several key differences in how they operate:

Funding and contributions.

With an ESOP, an employee does not contribute any of their own money. The company contributes shares of stock or cash to buy stock on an employee’s behalf.

With a 401(k), an employee funds the plan directly from their paycheck and the employer may choose to match a portion of an employee’s contributions.

Investment control.

An employee’s ESOP account is concentrated in their employer’s stock. Because it is not diversified, the value of their retirement is directly tied to the financial success of a single company.

By contrast, with a 401(k), employees typically choose from the investment options offered by the plan. This allows an employee to diversify their portfolio to manage and mitigate market volatility.

Vesting and distributions.

ESOP vesting usually occurs over several years, and ESOP shares are typically held in a trust and distributed or cashed out when an employee retires, leaves the company or becomes disabled.

With a 401(k), employee contributions are 100% vested immediately, while employer-matched funds often follow a vesting schedule. 401(k) distributions may generally be taken without the 10% additional tax after age 59½, although income taxes and plan-specific rules may still apply.

Risk and volatility.

With an ESOP, because an employee holds privately traded company stock, their share value is usually determined by an annual independent appraisal. If the company struggles, the employee’s balance may drop. If it thrives, the balance may grow rapidly.

A 401(k) balance can fluctuate daily based on the broader stock market, but an employee has the flexibility to shift their investments away from high-risk assets.

Potential drawbacks and considerations for employees.

While ESOPs offer a number of wealth-building benefits for employees, there are some key drawbacks:

• Lack of diversification: A large portion of an employee’s retirement portfolio is tied to the financial health of a single employer. If the company struggles or fails, both the employee’s job and retirement savings may be at risk.
• Strict vesting schedules: Employees do not immediately own all of their ESOP shares. Those who leave the company too soon may forfeit significant value.
• Payout timing: Depending on the plan’s terms and the reason for separation, employees may have to wait several years before receiving their vested ESOP benefits.

Ultimately, an ESOP can offer much more than a retirement benefit to employees. When workers share in the value that they help create, their interests and the company’s success become more closely aligned, which reinforces a culture of accountability and collaboration.