ESOP vs 401K Plan
Keep reading to understand each one and what makes them different from each other.
From our other articles on ESOPs, you might already have an idea of what one is. For those who don’t, an ESOP is an Employee Stock Ownership Plan that is used to offer compensation to the employees of a company. An ESOP is one of the more common methods used to transfer ownership of the company. It is also used for the sale of the company’s stock.
Business owners use this method mostly when they want to retire or when they want to use these shares as an incentive for retaining good talent in the company in the long run. With this said, another widely used retirement package for employees are 401Ks. Even though ESOP vs 401K are related to each other, when it comes down to the specifics, they are very different.
Keep reading to understand each one and what makes them different from each other. Let us begin with ESOPs.
ESOP programs are qualified retirement plans that are designed mainly for the purpose of transferring shares of ownership of the company to employees and executives. Even though these plans are available for publicly traded companies, they are very common among closely held private businesses that need a market for their shares. The ESOP plans are used to solve this problem by purchasing the shares from employees enrolled in the plan when they retire.
Plan Structure and Design
ESOP plans are the only type of plan for employee stock purchase plans or retirement plan that holds either cash or the company stock in a separate trust, where the employees are the beneficiaries and the stock is placed in their names in separate accounts. Basically, an ESOP plan is a defined contribution plan, but is very different from the other kinds of plans. This means that it can be established by C or S corporations, with plans for S corporations being more common.
No other kind of business entity can use them (including sole proprietorships, professional corporations, or partnerships). For creating an ESOP plan, the employer forms an ESOP committee, consisting mostly of owners and key management members along with some key employees or a representative for normal employees. The committee makes decisions about how the plan will be funded and operated, and appoints a trustee to run it.
ESOP programs are very unique in that they are normally funded only by employer contributions. The employer makes tax-deductible contributions to the employee accounts within the trust every year as per the predefined formula. This is calculated based on some combination of employee tenure and compensation on an individual basis. The employers normally finance the plan with the shares of their own stock, valued by an independent appraiser. But they might also make cash contributions as well.
ESOP plans have to follow some rules just like every other qualified equity distribution plan when it comes to vesting and participant eligibility. To begin with, the employee has to be at least 21 years old, and should have completed 1,000 hours of service in the company within a calendar year.
The vesting rules, modified by the Pension Protection Act of 2006, need the employers to use either:
- A graded vesting schedule, which provides 20% vesting every year after the second year of employment; or
- A cliff vesting schedule, which is 100% vested after 3 years or less, or on a graded vesting schedule.
Additionally, this rule is also governed by the IRS. So, to avoid any trouble that might arise, it is important to follow these vesting rules for the ESOP.
Employees who have participated in the ESOP plan for at least 10 years are permitted to diversify as much as a quarter of their plan assets into other investment vehicles when they reach age 55. Additionally, they can also diversify up to another 25% of their plan balance at age 60. The plan has to either:
- Permit the participant to roll over the amount into another plan like a 401k plan, also offered by the employer; or
- Provide at least three other investment alternatives like bonds or mutual funds.
The participants might also take a penalty-free distribution of this amount in case no alternative investments are offered by the employer.
ESOP employees can take distributions from their plans under a number of different situations:
- Hardship: Employees can take hardship distribution if allowed by the ESOP plan, but the hardship has to meet the criteria of the plan for this kind of event.
- Separation from Service: If an employee leaves the company for reasons that do not include retirement, disability or death, they might have to wait around 5 years before getting any distributions. They might also forfeit all or some of their plan assets if they are not completely vested when they separate from the service.
- Disability and Death: In such instances, age limits are waived by the company.
- Retirement: Employees who either retire early at age 55 or reach the normal retirement age of 59 ½.
- Miscellaneous Conditions: A few ESOP plans would also permit the participants to make distributions while they are still working for the company as long as they meet the prescribed age or tenure needs as set by the trust.
Distributions can be made over a period of time of no more than five years or in a single lump sum. The distributions can also be delayed to a great extent, if the ESOP has purchased its shares of the company stock using borrowed money. In such a case, the delay would be until the year after the loan is repaid.
When participants start taking distributions from the plan, the employer needs to make an offer to purchase the shares from the participant at a set price, which must stand for 60 days, as per the law. If the company’s stock is publicly traded, the employee can just sell the shares in the open market.
How does it work?
A trust fund is established when a company wants to set up an ESOP. After that, the company then contributes new shares of stock or cash to purchase existing shares in the trust. The shares are divided among the employee accounts within the trust. A plan is prepared and the rules are put in an ESOP document. Vesting schedules are added that would benefit both the employees and the company.
Employers pay ESOP distributions when employees leave the company. The employee receives the accrued stock, and the company has to repurchase the shares back from them at the fair market value (FMV) if there is no public market for them.
Advantages of ESOP
Many companies have incorporated ESOP plans into their company structure due to the many advantages. Here are the main advantages of the ESOP program:
- Dividend: Employers can pay dividends on the stock in the plan, which can then be paid directly in cash or used to purchase more shares of the company. ESOPs are the only kind of tax-deferred retirement plan that can pay out cash of any kind to the participants before they are otherwise eligible to take distributions without incurring a penalty.
- Workforce Motivation: ESOP plans can easily result in increased employee retention and productivity due to the share ownership of the company. Multiple studies have displayed that companies grow faster as soon as they have established an ESOP plan in the company.
- Tax Advantages: The tax benefits of the ESOP plan includes the deductible contributions and tax-deferred growth.
- Liquidity: ESOP plans create a liquid market for the company stock that employees can use to sell their shares. This is very advantageous for closely-held private companies with non-publicly traded shares.
Disadvantages of ESOP
Just like most things in life, ESOPs have some disadvantages as well. But if you follow the rules properly, these disadvantages can be reduced.
The disadvantages of the ESOP plan includes:
- Share Price Dilution: Creation and issuance of additional shares for new participants can dilute the value of all existing shares, which is a huge issue for closely-held businesses.
- Lack of Diversification: Since the ESOP plans are normally financed completely with the company stock, employees can become overweighted in this security in their investment portfolios. Due to this, a lot of the Sub S employers that offer ESOP plans also offer another qualified plan, like a 401K plan as an alternative. Employees can contribute to both plans at the same time.
- High Expenses: Companies that implement ESOP plans can incur very high creation and administration costs.
- Limited Corporate Structure: ESOPs can only be used by S or C corporations.
- Lower Payout: The share price obtained by the employees in a closely-held ESOP might not be as good as what they would get if the stock was publicly traded.
Is an ESOP a Qualified Retirement Plan?
As mentioned above, an ESOP plan is a qualified retirement plan. This means that this plan satisfies requirements laid out in the Internal Revenue Code Section 401(a). Besides this, employees shouldn’t depend completely on ESOPs as the only method of financing their retirement. For example, if the company stock fails to increase in value or decreases, the employee’s benefit remains flat or loses its value.
And if the company is shut down completely, the employee would lose all the benefits completely. While the varied investment options exist after an employee has participated in the ESOP for 10 years and has reached the age of 55 years, ESOPs can lack essential diversification. So, it is better to have a backup plan. And most employees choose to have a 401K plan. While you may have heard about this before, do you know all the details of this retirement plan?
The next section will help you understand it better.
What is 401K?
A 401(k) plan is an employer-sponsored contribution plan that both an employer and employee can make contributions to until the retirement age of the employee. But don’t confuse this with a pension plan. And you already know that an employer stock ownership plan is a trust established by the company that allows employees to own shares of the company’s stock. The administrator of an ESOP is legally required to invest the majority of the money in the company’s stocks.
Companies, along with the ESOP, also offer 401k plans as an incentive to employees in their company. In short, a 401K plan is a tax-advantaged plan. The investment earning in a traditional 401K plan are not taxed until the employee withdraws the money, which happens normally after their retirement. In a Roth 401(k) plan, withdrawals can be tax-free.
Contributing to a 401(k) Plan
These days, 401k plans are popular while the traditional pension system have become very rare. This is because employees have reduced the risk of their future by investing in it rather than being completely dependent on pension plans. Employees are also responsible for choosing the specific investments within their 401k account, from the selection that their employers offer.
Those companies normally offer an assortment of mutual funds along with target-date funds that hold a mixture of stocks and bonds for when that person expects to retire. They may also include guaranteed investment contracts (GICs) issued by insurance companies and sometimes the employer’s own stock.
The owners of both kinds of accounts have to be of at least 59½ years old or meet other criteria of the IRS such as being permanently and totally disabled. Otherwise, the owners will have to give a 10% penalty tax on top of any other tax they owe. Both kinds of accounts are also subject to required minimum distributions or RMDs. This means that after the age of 70½, the owners have to withdraw a minimum percentage from their 401k plans. However, if they are still working and the account is with their current employer, they might not have to take RMDs from the plan.
How does it work?
401k plans permits employees to save for their retirement by making tax-deferred contributions from their paychecks. Companies match the contributions of their employees up to a certain percentage or dollar amount. The contributions added in the 401k plan are used to invest in mutual funds, bonds, stocks, and other investments. And when the employee reaches a certain age, they are allowed to withdraw the amount from the account.
Advantages of a 401K
To help you understand why investing in a 401k plan is very good, here are the advantages of a 401k:
- Less Taxable Income: The money in a 401k plan is taken out of the employee’s paycheck before it is taxed by the government. With this, the employee will not just save money, but also pay less tax on that reduced income.
- Optional: One great thing about 401k retirement plans is that the employee has the choice to save for their retirement and can also sign up for other retirement plans. This does not tie a person down or keep him from choosing what he thinks will be for his best interest.
- Matching Savings: Another advantage of investing in the plan is that there are employers who offer plans and match the contributions of the employees. By doing so, the account value of the money will be increased since the employer will also put in the same amount of money in the retirement savings of the employee.
Disadvantages of a 401K
While 401k plans may seem like a good option for retirement, it also has some drawbacks as well. Here are the disadvantages of a 401k plan:
- Imposed Waiting Periods: In this plan, the employee has to wait for a certain period before they can sign up for their 401k plan. So, for those who want to start saving from an earlier time, it can be an issue.
- Forced Withdrawal: Along with the fee that has to be paid for early withdrawal, the employee also needs to withdraw their money when they reach the age of 70 and onwards. It is okay when a person wants to retire, but what if the person wants to work past the age of 70. This is a negative thing about the plan.
- Withdrawal Fees: If a person has an emergency and needs to withdraw money from the 401k, there may be a fee for an early withdrawal.
But if an employee feels that these points can be handled well, this plan is a great idea to opt for when working in a company.
ESOP vs 401K Plan
From the above, you might have understood that both ESOP plans and 401k plans are very different from each other, but both of them are retirement accounts offered by employers. With a 401k plan, the employer’s contributions are tax-deferred, meaning that the money is taken out of each paycheck before taxes, and those wages are not taxed until withdrawal. Whereas with an ESOP, employees also do not pay taxes on the shares in their account until distribution. In both situations, employers may offer matching contributions.
Here is a detailed differentiation of ESOP vs 401K plans:
- The company invests its money in the ESOP plan. It is a plan for those who cannot make a deduction from their payroll for the retirement plan. For those who can afford it, can also add a contribution to the plan. And in the 401K plan, the employees are the ones that invest their own money in the plan through payroll deduction.
- ESOPs purchase the company stock only. In the 401k plan, employees invest from a list of options based on what the company is offering them.
- Employees normally do not control the ESOP shares, while the employees are the ones who control their 401k accounts.
- In an ESOP plan, the employees usually need to wait for a long time before they get their shares. It can stretch out over several years. For the 401k plan, the employees get their funds instantly.
- The value of an ESOP account varies based on factors such as salary, tenure, when the employee leaves, macroeconomic events, etc. On the other hand, the company 401(k) match is a percentage of salary, which is easy for employees to understand and to compare against other potential employers.
To be on the safe side and to secure your future, it is advised by some to have both plans. So, if you are an employee in a company offering you both plans, take it. It would help you save a good amount for your future. And being an employer, it is always a great idea to offer many retirement options to your employees. This would encourage your staff to work longer in the company. But while you offer them with ESOP shares, do remember to keep track of them.
Eqvista is a great and cap table that will help you track and manage all the shares in your company. You can easily create ESOP plans on this application and issue the shares accordingly.