One of the most common topics of discussion for employee stock ownership plan (ESOP) participants is how ESOP distributions work. Understanding these rules and how they apply to your individual ESOP account can seem confusing. Here are three of the most frequently asked questions that professionals at FORVIS hear about ESOP distributions.
1. When Will I Receive My Distribution?
In general, most ESOP distributions are paid after a participant leaves employment. The timing of your distribution will be determined as follows:
- Retirement, death, or permanent disability – If you leave for any of these reasons, distributions must begin by the end of the plan year following the plan year in which the qualifying event occurs.
- Other terminations – If you leave for other reasons (such as quitting or being terminated), distribution must begin by the end of the sixth plan year following the plan year in which your termination occurs.
Some exceptions may alter the timing of your distribution:
- Leveraged ESOPs – If you have shares in your ESOP account that were bought with an internal loan, the distribution of those shares may be delayed until the plan year after the loan is fully repaid.
- General retirement plan rules – The Employee Retirement Income Security Act of 1974 has some general requirements that apply to all retirement plans. If these rules would require an earlier distribution, they can override any of the ESOP rules above.
- Distributions must start no later than the 60th day after the end of the plan year in which the later of the following events occur: 1) earlier of the plan’s normal retirement age or age 65; 2) 10th anniversary of participating in the plan; and 3) termination of employment.
- Required minimum distribution (RMD) rules – In general, an RMD is the minimum distribution that a participant must take from their ESOP account when reaching the age of 70 ½ (if you were born before July 1, 1949) or age 72 (if you were born after June 30, 1949) or age 75 for those who attain age 74 after December 31, 2032. This distribution must begin no later than April 1 of the first calendar year after retirement. If the participant owned a 5% interest in the plan sponsor at the time of the ESOP transaction, the participant must take an RMD regardless of termination.
2. How Will I Receive My Distribution?
Distributions are generally paid in one of the following methods:
- Lump sum – The entire account balance is paid out all at once.
- Installments – The account balance is paid out in substantially equal payments that are made at least annually. Payments must be made over no more than five years. (This means there can be six annual payments as the five-year period begins on the day the first payment is made.)
3. How Much Will I Receive?
The amount of your distribution will depend on the following:
- The value of the shares in your account
- The amount of cash in your account
- How vested you are in your account
Employees will become vested in a certain percentage of their account in the ESOP each year. All employees who attain normal retirement age under the plan become 100% vested in their account. By law, all other participants generally must be 100% vested based on one of the following schedules:
- Cliff vesting – No vesting at all in the first two years followed by immediate 100% vesting after three years of service.
- Graded vesting – Twenty percent vesting after the second year of service, increasing by 20% each year until 100% vesting occurs after the sixth year of service.
Amounts that are not vested will be forfeited by employees under the terms of the plan document.
Examples of the ESOP Distribution Rules
- Retirement, death, or disability – You retire in 2023 after turning 65. Distributions must begin the following year in 2024.
- Other terminations (non-leveraged) – You leave the company in 2023 at age 30. Distributions can be delayed until 2029 (six years later).
- Other terminations (non-leveraged) – You leave the company in 2023 at age 62 with 10 years of participation. Under the ESOP rules, distribution could be delayed until 2029 (six years later). However, under the general retirement plan rules, distribution must begin in 2027 (completion of age 65, 10th anniversary of participating in plan, and termination of employment).
- Other terminations (leveraged) – You leave the company in 2023 at age 30, but the shares in your account were purchased with an internal loan that’s scheduled to be repaid in 2040. Due to the loan exception, distribution can be delayed until 2041 (the year after the loan is repaid).
While there are general distribution rules that apply to all ESOP companies, it’s important to understand the distribution provisions included within your specific plan document as these can vary considerably from company to company. To find out more about your ESOP’s distribution provisions, please contact your ESOP administrator to request a current copy of the summary plan description or plan document.
For more information on ESOPs and these frequently asked questions, please reach out to a professional at FORVIS or use the Contact Us form below.