What Is an ESOP?

6 Min Read | Published: March 5, 2024

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This article contains general information and is not intended to provide information that is specific to American Express products and services. Similar products and services offered by different companies will have different features and you should always read about product details before acquiring any financial product.

An Employee Share Ownership Plan (ESOP) allows employees to acquire shares in the company they work for. Learn how an ESOP works, and what happens if you leave.

At-A-Glance

An Employee Stock Ownership Plan (ESOP) gives employees ownership interest in the company.
ESOPs are long-term investments treated as retirement benefits.
ESOPs may be able to be rolled over into a traditional IRA or Roth IRA, but it’s important to speak with your accountant first.

What Is an Employee Stock Ownership Plan?

An Employee Stock Ownership Plan (ESOP) is a retirement benefit program that gives employees a vested interest in the company they work for. When they participate, they gain ownership interest in the company in the form of shares of stock.¹

ESOPs are usually part of a corporate benefit package set up as a trust fund that can be used to purchase existing or newly issued company stock. The shares are then allocated to employee’s accounts. Distribution of shares may be based on the employee’s pay scale, number of years with the company, or something else. ESOPs are typically treated as long-term investment plans.²

How Does an ESOP Work?

ESOPs can vary in how they are structured and implemented. While they are subject to specific regulations, how the plan operates can vary.

The administrator of an ESOP doesn’t simply give away shares of stock. The stock, which can be existing or new, is purchased by a trust fund where it’s held for the duration of the participant’s employment with the company. In most cases, there’s a vesting period, before employees are entitled to receive them. The vesting period varies but is typically anywhere from one to five years.³

Example ESOP Timeline:

Year 1: A new employee gets hired and is offered ESOP rights to 100,000 shares of common stock, but they need to stay with the company for a specific number of years.

Year 5: In this example, the shares become fully vested once the vesting period is over (in this example, five years). However, it’s important to note that typically the employee does not receive the stock even after the vesting period is over. In most cases, it is held in the trust fund until the employee leaves the company.

Year 12: The employee retires, leaving the company. The ESOP is then typically required to begin distributing the employee’s benefits during the plan year that follows retirement. Distributions can either be made in a lump sum or substantially equal payments over a period of five years or less. Exceptions to distribution timelines may apply in some cases.⁴

Benefits and Drawbacks of ESOPs

There are various upsides to incentivizing employees with an Employee Stock Ownership Plan:

ESOPs may help to attract and help retain good talent.
They offer a potential wealth-building opportunity for employees.
ESOPs may also provide certain tax benefits to employers and employees.⁵

The downside of an ESOP is its complexity:

Setup and management can be time-consuming and costly.
Both the U.S. Department of Labor and the Internal Revenue Service have strict rules on the sale and distribution of corporate stock.

How to Cash Out an ESOP

Being vested may not necessarily mean you can cash out of your ESOP. Generally, you can only redeem these shares if you terminate employment, retire, die, or become disabled.⁶ Check the terms in your plan’s guidelines to see what the distribution rules are.

ESOPs can make it difficult to get a cash payout before age 59 ½, or 55 if terminated, and, if it is allowed, they could be subject to a 10% early withdrawal penalty.⁷

You may be able to avoid penalties and continue deferring your tax liability by rolling over your ESOP into a traditional IRA. You may also consider rolling it into a Roth IRA, but then you’d need to pay taxes on the money now.⁸ Consider speaking with a certified accountant about each of these options. Your ESOP trustee may also be able to help with this.

Frequently Asked Questions

Company cash and stock contributions to the Employee Stock Ownership Program are allocated to the accounts of participating employees in the ESOP trust. The account balance remains tax-deferred until it is distributed to the participant, typically after retirement or termination.⁹

An ESOP is governed by a trustee who is a fiduciary required to act in the best interest of the participants and beneficiaries.

The Takeaway

ESOPs are retirement benefit plans that can help to incentivize employees. An ESOP is set up as a trust fund to purchase new and existing company stock. That stock is awarded to plan participants and may be subject to a vesting schedule. Speak with an accountant to learn more about the implications of a rollover from an ESOP into a traditional or a Roth IRA.

^1,2,6,7 “Employee Stock Ownership Plan (ESOP): What It Is, How It Works, Advantages,” Investopedia

³ “What Is The Vesting Period Of An ESOP?,” FI Money

^4,9 “ESOP Distribution & Taxation: How Does it Work? What Are the Rules?,” ESOP Partners

⁵ “Employee Stock Ownership Plans (ESOPs),” Internal Revenue Service

⁸ “What’s the Best Way to Handle ESOP to IRA Rollovers on IRS Form 1099-R?,” ESOP Partners

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Kevin D. Flynn is a financial services provider, business coach, and financial writer. He lives in Leominster, Massachusetts with his wife Evelyn, two cats, and ten wonderful grandchildren.

All Credit Intel content is written by freelance authors and commissioned and paid for by American Express.

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