Employee ownership can be a very meaningful financial benefit for many workers. For some, that ownership comes through stock options or restricted stock. For others, the most common example being those who work in privately held companies, it may come through an Employee Stock Ownership Plan, often called an ESOP.
An ESOP can become a significant retirement asset, sometimes representing a large part of a retiree’s nest egg when they separate from service. This oftentimes raises some important questions, including:
What exactly do I own? When can I access it? Should I keep the company stock when I retire? Should I roll over the account into an IRA? And could Net Unrealized Appreciation, or NUA, provide a better tax strategy?
These are important questions for employees across Huntsville and North Alabama to consider, especially as retirement or separation from service approaches.
What is an ESOP?
An Employee Stock Ownership Plan is a type of qualified defined contribution plan designed to invest primarily in the stock of your employer. Rather than employees purchasing the shares directly, the ESOP has a trust that holds the company’s shares on behalf of employees who are eligible. Shares are then allocated to participant accounts according to the terms laid out in the plan.
Put simply, an ESOP allows employees to gain and build an ownership interest in the company where they work.
As the employee continues to work and satisfies vesting requirements, their vested account balance can grow based on additional share allocations and/or changes in the value of the company’s stock.
This can make an ESOP a great tool to build wealth. For some employees, it can also become a large portion of their retirement savings.
How Does an ESOP Work for Employees?
The details can vary from company to company, making the Summary Plan Description (SPD) document very important.
The plan generally establishes:
- Who is eligible to participate
- How shares are allocated
- How vesting works
- How company stock is valued
- When distributions begin
- Whether distributions are made in stock or cash
- What happens after retirement, death, disability, or other separation from service
The Department of Labor specifically states that an ESOP’s SPD should explain participant rights, share allocation, distributions, and what happens when an employee separates from service.
For employees approaching retirement, understanding these provisions before you end up separating from service is critical.
How is an ESOP different from a 401(k)?
An ESOP and a 401(k) are both defined contribution retirement plans, but are both different in their own ways.
A traditional 401(k) allows employees to defer part of their compensation and invest those dollars among various investments. On the contrary, an ESOP is designed to primarily hold employer stock.
This creates an important distinction when it comes to diversification.
A 401(k) might be made up of:
- S. stocks
- International stocks
- Bonds
- Target-date funds
- Money-market instruments
An ESOP is often concentrated in one company.
This concentration can produce substantial wealth when the company performs well, but also creates greater company-specific risk and diversification issues.
How is an ESOP Different from an ESPP?
An Employee Stock Purchase Plan, or ESPP, allows employees to use their payroll deductions to purchase employer stock, which is often at a discount.
With an ESOP, employees usually accumulate their ESOP interest through employer contributions and allocations under the retirement plan, instead of purchasing shares with a portion of each paycheck.
How is an ESOP Different from RSUs and Stock Options?
Restricted Stock Units, or RSUs, provide employees with shares or cash after certain vesting requirements are met.
Stock options give the employee the right to purchase shares at a predetermined exercise price.
Both can be important forms of compensation, especially for executives.
However, unlike an ESOP, which is a qualified retirement plan, RSUs and stock options are forms of equity compensation, not qualified retirement plans, so they don’t offer rollover or NUA treatment.
The difference becomes important at retirement because distributions from an ESOP may qualify for rollover treatment and potentially favorable tax treatment as well.
What Happens to My ESOP When I Retire?
The answer to this depends primarily on the conditions outlined in your ESOP’s SPD.
Qualified retirement plans generally make distributions after events such as retirement or separation from service, but the SPD determines the precise timing and what forms of distribution are available.
Depending on the plan, an employee may receive:
- A lump-sum distribution
- Installment payments over several years
- Employer stock
- Cash representing the value of the shares
- Some combination permitted under the plan
Employees retiring before age 59½ should also consider the potential 10% early withdrawal penalty. An important exception may apply if you separate from service during or after the calendar year in which you turn age 55, allowing qualifying distributions from that employer’s plan to avoid the penalty. However, that age-55 exception generally does not carry over once the assets are rolled into an IRA.
Employees of privately-held ESOP companies should pay close attention to the distribution provisions outlined in their plan’s SPD, as private company shares are not liquid or easily sold like stock on a public stock exchange.
This makes it especially important to determine how the plan will value and redeem the employee’s ownership interest.
What Happens to My ESOP Shares if I work for a Privately-Held Company?
Privately held ESOP shares require different planning than publicly traded company stock because there is no public market where the shares can be bought or sold.
In most privately companies who have ESOPs, employees do not continue to hold the shares in a traditional brokerage account or IRA after retirement or separation from service.
Instead, the company or plan will oftentimes repurchase the employee’s vested shares according to the terms of the plan in the SPD, and the employee ultimately receives cash representing the value of those shares.
That cash may be eligible to be rolled into an IRA, allowing the retiree to continue to defer taxes and invest the proceeds in a diversified portfolio.
In some plans, shares may be distributed before being sold back to the company, which can create tax-planning considerations, including whether Net Unrealized Appreciation, or NUA, applies.
Because distribution and repurchase options vary significantly from one privately held ESOP to another, reviewing the plan documents before retirement to understand whether you should receive shares, cash, or shares subject to a company repurchase requirement.
Should I Roll My ESOP Into an IRA When I Retire?
Rolling a qualified retirement plan balance into an IRA can be attractive for many retirees.
Benefits include:
- Broader investment choices
- Easier diversification
- Consolidation of retirement accounts
- Simplified investment management
- Greater flexibility for future withdrawals
- Easier coordination with Roth conversions and retirement-income planning
A well-executed rollover of an eligible balance to a traditional IRA generally defers current income taxation on the balance.
However, it is important to note that employees who own highly appreciated stock should avoid rolling over everything into an IRA until they have evaluated the Net Unrealized Appreciation, or NUA, option.
This option can have long-term tax consequences.
What is Net Unrealized Appreciation, or NUA?
Net Unrealized Appreciation is the growth in value of employer stock while it was held inside a qualified retirement plan.
For example, if an employee has:
A cost basis of: $100,000
Current plan market value: $500,000
The NUA would be: $500,000 – $100,000 or $400,000
Under qualifying circumstances, the employee may be able to distribute publicly-held employer securities to a taxable brokerage account rather than rolling these shares into an IRA.
In terms of taxation, the participant usually recognizes ordinary income on the cost basis when the securities are distributed, while the $400,000 of NUA can remain tax-deferred until the stock is sold. When the NUA portion is eventually sold, it is treated as long-term capital gain instead of ordinary income, ultimately receiving a step-up in basis to heirs at death.
This can create a valuable difference.
If the stock were to have been rolled over to an IRA instead, withdrawals would be taxed as ordinary income.
When Can NUA Treatment Apply?
Unfortunately, the NUA rules are highly technical.
For favorable treatment, the IRS generally requires the participant’s entire balance from all of the employer’s qualified plans of the same type to be distributed within a single tax year after a qualifying event.
Qualifying events include but are not limited to:
- Separation from service
- Attaining age 59 ½
- Death
- Disability (only for self-employed participants)
The IRS defines a qualifying lump-sum distribution as the employee’s entire balance from all the employer’s plans of one kind within a single tax year, making it imperative to be carefully evaluated before initiating distributions.
What is the Hybrid NUA and IRA Rollover Strategy?
This is one of the most useful yet misunderstood strategies involving employer stock.
Many retirees assume they have only two choices:
- Roll everything into an IRA
- Elect the NUA option
However, there is a third option.
An employee who qualifies may:
Distribute the employer stock in-kind to a taxable brokerage account via NUA treatment on those shares, while directly rolling the remaining diversified retirement-plan assets into an IRA.
This is often referred to as a hybrid NUA strategy.
The IRS permits employees to roll over all or part of an eligible lump-sum distribution, and brokerage firms, such as Fidelity, allow you to choose whether to roll over all the retirement-plan assets into an IRA or distribute a portion to an IRA and the rest to a taxable account.
This combination can prove to be tremendously useful.
How Does a Hybrid NUA Strategy Work?
Consider an employee retiring with $1 million in their qualified plan balance consisting of:
Employer Stock | $400,000 |
Diversified Investments | $600,000 |
Of the employer stock, assume a:
Cost Basis | $80,000 |
Market Value at Distribution | $400,000 |
NUA | $320,000 |
Instead of rolling the entire $1 million into an IRA, the employee could structure a qualifying distribution so that:
$600,000 of diversified investments goes to a traditional IRA
$400,000 of employer stock goes into a taxable brokerage account
Under qualifying NUA treatment, the employee would recognize ordinary income on the $80,000 cost basis.
The $320,000 of NUA would remain untaxed until the shares are sold, at which point they would be treated as long-term capital gain.
Lastly, the $600,000 that was rolled directly into the IRA would remain tax-deferred, giving the retiree access to two different accounts with two different tax treatments instead of rolling everything into an IRA.
When Might Rolling Everything into an IRA be Better than Electing the NUA Option?
Electing the NUA option is not automatically the best outcome.
For example:
Cost Basis | $450,000 |
Value at Distribution | $500,000 |
NUA | $50,000 |
Employer stock worth $500,000 that has a high basis of $450,000 would only have $50,000 of gain to elect the NUA option on.
The employee would need to recognize ordinary income on the $450,000 basis upfront in order to preserve the capital gain treatment on the $50,000 of appreciation.
In this particular situation, rolling over the $500,000 into an IRA may be more attractive.
Important factors to compare include:
- Employer-stock cost basis
- Amount of NUA
- Current ordinary income-tax rate
- Expected future ordinary tax rate
- Capital-gains rate
- State taxes
- Medicare IRMAA
- Required minimum distributions
- Expected holding period
- Charitable intentions
- Estate planning
- Need for diversification
- Cash available to pay taxes
The question you should be asking isn’t, “Can I elect the NUA option?”, but “Does electing the NUA option improve my overall retirement plan?”
Should I sell the Employer Stock Immediately After Using NUA?
Often yes, at least gradually.
When you elect NUA and continue holding the company stock, those are two separate decisions that each have their own impact.
The tax strategy may justify distributing the shares to a taxable account, but from there the investment strategy may call for selling those shares to achieve adequate diversification.
For example, a retiree could elect NUA to preserve the favorable tax treatment on the appreciation, gradually selling shares as time goes on to create a diversified portfolio.
The employee does not have to continue to subject themselves to the concentration risk that comes with having a large part of their portfolio in a single company’s stock.
How are Taxes Calculated After an NUA?
Looking at company stock with:
Cost basis | $100,000 |
Value at distribution | $500,000 |
NUA | $400,000 |
At distribution, the $100,000 cost basis is included in ordinary taxable income.
The $400,000 is deferred.
If the retiree were to sell the stock 6 months later for $550,000, the tax treatment for the gain would be separated into two pieces:
$400,000 of original NUA treated as long-term capital gain
$50,000 of additional appreciation after the distribution
Since the stock was sold 6 months after distribution, the $50,000 gain after distribution would be classified as short-term capital gain, which would be taxed as ordinary income.
If the retiree were to sell the stock 13 months after distribution, the $50,000 would be taxed at long-term capital gain rates.
This distinction should be tracked carefully.
How Can NUA Affect Medicare IRMAA?
Tax planning goes beyond income-tax brackets.
Recognizing the cost basis of employer stock in the year of a NUA distribution increases taxable income and may affect Modified Adjusted Gross Income, or MAGI.
For retirees who are enrolled in Medicare, this recognition of income could increase future Medicare Part B and D premiums through IRMAA.
That does not necessarily make electing NUA unattractive, it simply means your analysis should include:
- Income tax generated by the distribution
- Potential IRMAA costs
- Future IRA taxation
- Future required minimum distributions
- Capital-gain treatment
- Survivor planning
A strategy can still be worthwhile, even if it temporarily increases Medicare premiums.
For a deeper look at how retirement income and Roth conversions can affect Medicare premiums, read our article on IRMAA and Roth conversion planning.
Should I Diversify My ESOP?
For many retirees, this is a very important consideration.
Remaining invested in a single stock of a former employer, especially if it is a large portion of your retirement nest egg, can have serious repercussions on your retirement plan.
A useful question to ask yourself is:
If I had this amount in cash today, how much would I choose to invest in my former employer?
If the answer is significantly less than the current position, diversifying may be appropriate.
Can I Donate Appreciated Employer Stock to Charity?
For retirees who are charitably inclined, employer stock that has been distributed into a taxable account or an IRA may potentially become a useful charitable asset.
With the NUA portion, rather than selling appreciated stock and donating cash, a retiree can donate appreciated shares directly to an eligible charity or donor-advised fund (DAF).
With the portion rolled into an IRA, especially for retirees at the age of required minimum distributions (70 ½), distributions can be donated to a qualified church or charity through a qualified charitable distribution (QCD), avoiding the ordinary income tax that usually comes with an IRA distribution.
Depending on the circumstances, this may help:
- Reduce concentrated company-stock exposure
- Avoid recognizing some embedded capital gain
- Support charitable goals
- Potentially generate a charitable deduction subject to applicable limitations
For retirees planning to give, the choice of which asset to donate can be just as important as the amount given.
What are the Biggest ESOP Mistakes to Avoid at Retirement?
One of the biggest mistakes is automatically rolling everything into an IRA without first evaluating the tax treatment of the employer stock.
Another mistake is assuming NUA is automatically the best option simply because there is a low cost-basis and substantial appreciation exists.
Retirees should avoid:
- Ignoring cost basis
- Failing to understand the plan’s distribution rules
- Taking partial distributions without understanding their effect on a potential lump-sum NUA strategy
- Maintaining an excessive company-stock concentration simply because the stock performed well historically
- Making stock and IRA decisions without considering Medicare IRMAA
- Waiting until after retirement to review the plan documents
The sequence of which transactions occur can be just as important as the transactions themselves.
Final Thoughts
For many employees in Huntsville and across North Alabama, employer stock and ESOP benefits can become a meaningful part of retirement wealth, particularly after a long career with a growing local business, defense contractor, engineering firm, manufacturer, or other employee-owned company.
But accumulating company stock is only part of the equation. As retirement approaches, the more important question becomes how that stock fits into the rest of the financial plan.
Wise ESOP and employer-stock planning may involve evaluating NUA, considering a hybrid NUA and IRA rollover strategy, reducing unnecessary concentration, coordinating taxes and Medicare, and determining how much company stock still makes sense to own after employment ends.
These decisions are often most effective when they are made before the retirement date and before assets are automatically rolled over or distributed.
At Anthem Advisors, we believe retirement planning should help families steward the wealth they have built with greater clarity and purpose. Employer stock may represent years of hard work, but the next step is making sure those assets are positioned to support retirement income, generosity, family goals, and legacy for the years ahead.
For employees approaching retirement with a substantial ESOP or other company-stock position, thoughtful planning today can help turn years of employee ownership into a more diversified, tax-aware, and intentional retirement strategy.
“Plans fail for lack of counsel, but with many advisers they succeed.” Proverbs 15:22.
Disclosure: This material is provided for informational and educational purposes only and should not be construed as personalized investment, legal, tax, or accounting advice. Advisory services are provided only pursuant to a written advisory agreement. Information contained herein has been obtained from sources believed to be reliable; however, we do not guarantee its accuracy or completeness.
FAQs:
What is an ESOP?
- An Employee Stock Ownership Plan, or ESOP, is a qualified retirement plan designed primarily to invest in the stock of the sponsoring employer. Employees typically receive shares through the plan over time and build an ownership interest in the company as they become vested.
What happens to my ESOP when I retire?
- It depends on the specific plan. You may receive company stock, cash representing the value of your shares, installment payments, or another form of distribution permitted by the ESOP. Privately held ESOPs often ultimately distribute cash or require shares to be sold back to the company.
Should I roll my ESOP into an IRA at retirement?
- An IRA rollover can preserve tax deferral and provide greater investment flexibility and diversification, but it is not always the best choice. Before rolling over an ESOP containing employer stock, consider whether Net Unrealized Appreciation, or NUA, could provide more favorable tax treatment.
What is net unrealized appreciation, or NUA?
- NUA is the increase in value of employer stock while it is held inside a qualified retirement plan. Under certain conditions, distributing qualifying employer stock to a taxable brokerage account can allow the appreciation to eventually be taxed at long-term capital gains rates rather than ordinary income tax rates.
What is the Hybrid NUA and IRA Rollover strategy?
- A Hybrid NUA strategy involves distributing qualifying employer stock to a taxable brokerage account for NUA treatment while directly rolling the remaining eligible retirement-plan assets into an IRA. This can combine potential capital gains treatment on the employer stock with continued tax deferral on the rest of the retirement account.
Should I sell the employer stock immediately after using NUA?
- Using NUA and deciding whether to continue holding the stock are separate decisions. Selling some or all of the shares after distribution may help reduce concentration risk while still preserving the special tax treatment available on qualifying NUA.
Can I donate employer stock to charity?
- Yes, publicly traded employer stock held in a taxable account may often be donated directly to a qualified charity or donor-advised fund. Donating appreciated shares can potentially reduce concentration, avoid realizing embedded capital gains, and support charitable goals, subject to applicable tax rules.
- Internal Revenue Service, Employee Stock Ownership Plans (ESOPs)
https://www.irs.gov/retirement-plans/employee-stock-ownership-plans-esops?utm - U.S. Department of Labor, Employee Ownership Initiative and ESOP Resources
https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/programs-and-initiatives/employee-ownership-initiative/tools-and-resources/esops?utm - Internal Revenue Service, Publication 575: Pension and Annuity Income
https://www.irs.gov/publications/p575?utm - Internal Revenue Service, Rollovers of Retirement Plan and IRA Distributions
https://www.irs.gov/retirement-plans/plan-participant-employee/rollovers-of-retirement-plan-and-ira-distributions?utm - Internal Revenue Service, Topic No. 413: Rollovers From Retirement Plans
https://www.irs.gov/taxtopics/tc413?utm - Internal Revenue Service, Exceptions to Tax on Early Distributions
https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-exceptions-to-tax-on-early-distributions?utm - Internal Revenue Service, Retirement Topics: Termination of Employment
https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-termination-of-employment?utm
