What to Do When You Enroll in an ESOP Depending on your company, your employer may offer different benefits packages and retirement plans. One less familiar type of plan you may encounter is an employee stock ownership plan (ESOP)....

Depending on your company, your employer may offer different benefits packages and retirement plans. One less familiar type of plan you may encounter is an employee stock ownership plan (ESOP). If you haven't dealt with these before, you'll understandably have some questions when your employer offers you one.

Nearly 14 million people in the U.S. currently participate in an ESOP across various industries and company sizes. However, like any other type of benefits package, these plans aren't ideal for everyone. They can be highly beneficial in some circumstances but may not be as attractive in others.

You should ask certain questions before enrolling in an ESOP and take steps to make the most of it. Here's everything you need to know.

Understanding ESOPs

Because ESOPs aren't as common as some other retirement and benefit plans, you may not understand them. It's crucial to take the time to learn more about them before making a decision. In that spirit, here's a look at what an ESOP is, its benefits, and the potential downsides.

What Is an ESOP?

In the broadest sense, an employee stock ownership plan is a benefit where employers give employees an ownership interest in the company. That often means distributing stock shares or the ability to purchase them, and this can happen in a few different ways.

There are three main types of ESOPs:

• Leveraged
• Unleveraged
• Issuance

In a leveraged ESOP, your employer borrows money to fund the plan, using a loan to buy shares they then distribute to you. This means employees may get more upfront. By contrast, an unleveraged ESOP involves the business buying and distributing shares over a longer, more gradual period, so you may get more the longer you stay with the company.

Issuance ESOPs are less common and involve creating new shares in the company to put toward the plan instead of buying existing ones. That means your shares may lose their value over time, but you may get more.

Regardless of what kind of ESOP your employer offers, you typically won't get your shares until you leave the company. Some businesses may offer regular bonuses from these funds instead, but that isn't common.

Advantages of Enrolling in an ESOP

There are several advantages you should know about if you're considering enrolling in your company's ESOP. One of the most significant benefits is that these accounts are not taxable to employees as long as they remain in the ESOP trust. You don't have to pay taxes on these funds until you get them when you leave the company.

Similarly, you don't have to pay into ESOPs, either. Unlike other retirement plans like a 401(k), these accounts are entirely employer-funded. Enrolling in one won't affect your salary or ongoing expenses for as long as you're with the same company.

Because ESOPs are a matter of company stock, you can also influence how much you get from them. This is one of the main draws on the employer's side of things because it ties employee rewards to performance, but it can benefit you, too.

The better the company performs, the more valuable its stocks will be, giving you a larger sum when you quit or retire. Consequently, you can exert some control over how much you get by working harder or investing more in the business's success. If that doesn't work and share prices don't perform well, you can still sell them at a profit because you didn't contribute your own money to them.

Potential Concerns

ESOPs have plenty of benefits, but they also come with some possible downsides. It's important to understand these so you can make the best decision about whether to enroll or not.

Most notably, ESOPs can be risky compared to other retirement plans. Remember, the stock market is inherently volatile. You won't necessarily lose money because you're not funding the account, but poor stock performance will reduce your retirement savings. As a result, ESOPs can make long-term financial planning difficult.

Similarly, ESOPs lack diversification, so they're not ideal as your only source of retirement funding. You can't access your ESOP account until you leave the business, so the entire amount will remain in company stock, which is risky. However, if you've participated in the plan for 10 years or more and are 55 or older, you have the legal right to diversify your ESOP account.

It's also worth noting that you may not get all of your ESOP balance if you leave the company early. These plans typically follow a process called vesting, where you gradually earn your shares. Consequently, early retirement or quitting could cost you some or all of them, leaving you with no retirement savings.

Determining if an ESOP Is Right for You

Given these pros and cons, you should take the decision to enroll in ESOP seriously. It could be highly beneficial depending on your situation, but it may not fit your needs in others.

One of the first things to look at when your employer offers ESOP enrollment is the vesting schedule. Your employer may not vest at all, which is helpful because that lets you take all your shares with you when you leave, regardless of timing. However, most companies will follow one of two vesting schedules outlined by the IRS.

The first vesting schedule gives you nothing until you've enrolled in the plan for five years. At that point, you'll have full rights to 100% of your ESOP account. The second schedule starts vesting at the three-year mark when you're guaranteed 20% of the account. From there, you get:

• 40% at four years
• 60% at five years
• 80% at six years
• 100% at seven years

See what kind of schedule your employer offers, then consider how long you plan on staying at the company. If you think you'll be there for more than five years, the first timeline is best, but if not, the second may be safer. How your company's schedule lines up with your goals should help you make the right decision.

You should also consider your other retirement and benefits options. You can comfortably enroll in the ESOP if you already have a separate retirement savings account or your company offers a 401(k). If not, it may be too risky, as ESOPs aren't reliable or diverse enough to be your only fallback.

Finally, consider your company's stock. Enrolling in the ESOP is less risky if it has a long history of strong performance. However, if it's shown a lot of volatility or is relatively young, you may want to consider something else.

Making the Most of Your ESOP

You should keep a few things in mind if you decide to go through with your employer's ESOP. These steps will help you make the most of these plans for maximum safety and returns.

Steps to Take at Your Company

The most important step to take when you enroll in an ESOP is to ensure you have other retirement plans. It's best to view these as a bonus to your retirement savings, not your main funding source.

If your employer lets you participate in both a 401(k) and an ESOP, do it. Be sure you contribute enough to the 401(k) to get the full match if your employer contributes. This will give you a more reliable, diversifiable fund to fall back on if your ESOP returns aren't ideal.

If your company doesn't offer a 401(k), you may want to set up an independent retirement account (IRA). In most cases, you don't have to pay taxes on IRAs until you withdraw from them, like an ESOP. You may also be able to deduct your IRA contributions, which is helpful. You may not save as much with these accounts as a 401(k), but they're still a useful way to back up an ESOP.

Keep an eye on your company's stock performance while you're enrolled. This will help you decide what to do with your shares when you retire or leave the company. You may want to sell them immediately or wait until you can get a higher price.

Steps to Take When You Leave

There are some things to know when it comes time to leave the company. You should monitor your ESOP account to understand how much you can expect to receive as you get closer to retirement. Your company should send you annual statements that give you this insight, but if they don't, contact HR or payroll to ask them for a copy.

How your distributions work can vary. Some companies will give you a lump sum, while others will pay you in annual installments. They may buy all your shares when you retire if offering installments, then give you an equal amount each year. However, they could sell an equivalent portion of shares each year, which will fluctuate in value.

Depending on how your distribution works, your next steps may vary. Getting a lump sum or an equal amount every year makes planning easier. If that's the case with your ESOP, add these figures to your returns from other retirement plans to form an annual budget.

The process may look a little different if you're getting an equal portion of shares, not cash. Keep a close eye on company stock performance to help predict how much you'll get each year. Leave some room for error when budgeting, planning for less rather than more to be safe.

Enroll in an ESOP With Confidence

Enrolling in an ESOP doesn't have to be an intimidating journey if you know what to expect. Now that you know what you can gain and may risk, you can better decide if an ESOP is right for you. You can then confidently plan your retirement and make the most of your financial situation.

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