Considerations When Receiving a Distribution from an Employee Stock Ownership Plan (ESOP)

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Tax Implications of an ESOP Distribution

It is especially important to consider the possible tax implications of an ESOP distribution. Generally, ESOP distributions are taxed as ordinary income in the year they are received. If the ESOP was held in a tax advantaged account and you are under the age of 59 ½, then there may be early withdrawal penalties (in addition to income tax) if money distributed from the ESOP is moved out of tax advantaged accounts and into brokerage accounts or cash. It is crucial to understand the tax rate that will apply to your ESOP distribution. We are often asked about the application of IRS Rule 72(t) when someone receives an ESOP distribution. The details of Rule 72(t) can be found here. A financial advisor at One Day In July can help you work through the details of your specific plan and make sure you are investing the ESOP distribution in the most optimal way.

ESOP Rollover Opportunities

If the ESOP was held in a tax advantaged account and you want to avoid paying income tax (and penalties if you’re under 59 ½) on the distribution in the year it is received, then you may want to consider rolling the distribution into a tax advantaged individual retirement account (IRA). IRAs often have broader investment options than workplace 401k plans and can frequently allow you to reduce investment fees in comparison to a workplace plan.¹

Cash Flow Needs

Receiving a large amount of money from an ESOP distribution can be overwhelming. If the distribution is coming from a tax advantaged account, then you may want to roll the bulk of it into a similarly tax advantaged account in order to avoid a huge tax bill in the year it is received, and to keep the money from the distribution working for you long term. However, you may also want to use a portion of the ESOP distribution to pay off debt or fund a large purchase in the short term. In this case, it is important to calculate the tax implications and possible penalties that could come from taking the distribution if you are not at retirement age. A One Day In July financial advisor can work with you to determine the best strategy to help you achieve both your short- and long-term goals. Each person’s situation is going to be different. Working with a fiduciary at One Day In July can help you ensure that you are making the most of your ESOP distribution, and not losing big portions to taxes, withdrawal penalties, or high investment fees.

1. The decision to rollover a workplace retirement plan into a personal IRA should be considered on a case-by-case basis, as it may not always be the most prudent choice, depending on the specific facts and circumstances of the case.