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Retirement Planning

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Employee Stock Ownership Plans

An Employee Stock Ownership Plan (ESOP) is a type of retirement plan designed to invest in the stock of the participant’s employer. Generally, an ESOP is required to give employees the right to demand benefits in the form of the employer’s common stock, and if such stock is not traded on an established public market, the right to require the employer to repurchase the stock later under a fair valuation formula.

Benefits for Employees

In addition to being an attractive part of an employee’s compensation package, ESOPs are:

  • tax-deferred retirement savings and investment vehicles
  • funded by employer contributions
  • given special tax treatment for certain types of withdrawals

Benefits for Employers/Owners

ESOPs also provide employers and company owners with:

  • the ability to compensate employees with stock rather than cash
  • a tax-deduction for plan expenses
  • a vehicle through which owners can diversify their company stock holdings into other assets while directly rewarding employees

Contributions & Vesting

Contributions to an ESOP are typically subject to the same restrictions as those in other retirement plans. Combined contributions among all retirement plans in 2008 must not exceed the lesser of: 1) 100% of the participant’s compensation, or 2) $46,000. Catch-up contributions (for elective deferrals only) by participants age 50 and over may also be made. These amounts will be indexed to inflation in future years.

Although requirements vary by plan, benefits generally begin accruing to each participant:

  • after attainment of age 21, and
  • after completion of 1 year (under a phased vesting schedule) or 3 years of service

Phased vesting of benefits refers to the participant’s incremental ownership of plan assets depending upon completed years of employment. For example, a 6-year vesting schedule provides 20% ownership after 2 years, 40% ownership after 3 years, 60% ownership after 4 years, 80% ownership after 5 years, and 100% ownership after 6 years.

Taxation

Contributions:

Employer contributions are not taxable to the employee in the year they are made.

Withdrawals:

Withdrawals made in cash from any retirement plan, including an ESOP, are taxed as ordinary income for the year in which they are taken. Penalties may also apply if withdrawals are made before the participant reaches age 59 1⁄2.

Unique Advantages of an ESOP

Special rules exist for ESOPs that provide unique advantages relative to other types of retirement plan accounts. Employees who leave the employer sponsoring the ESOP may choose to withdraw the shares in-kind from the ESOP and hold them directly, rather than transferring them to another qualified retirement plan or IRA account.

By taking stock in-kind out of an ESOP, the former employee will owe ordinary income taxes for the withdrawal, but only on the cost basis for the shares distributed, not their current market value. (The cost basis is the value of the shares at the time they were contributed to or purchased for the participant’s ESOP account.) Also, the cutoff age for early withdrawal penalties is lowered to age 55 (from 59 1⁄2) for ESOPs, and applies only to the cost basis. Furthermore, the future sale of distributed shares may be taxed at long-term capital gains tax rates, not ordinary income tax rates. For shares which have greatly appreciated over the years, the tax savings can be substantial. Thus, this option could provide significantly more after-tax income than would be provided if the assets were withdrawn in cash or transferred into an IRA account.

Issues

Although ESOPs can provide substantial benefits to a participant, they may also present important issues that the employee will need to address carefully. Two common issues are:

Concentration of Wealth

Being employed by a successful company can be greatly rewarding, personally and financially. However, employees may find that a substantial portion of their personal wealth is tied up in the company, either in the salary and benefits earned from the employer or in the value of the employer’s stock. They lack sufficient diversification in case the employer’s circumstances and/or the stock’s market price hit a downturn.

Fortunately, Federal rules require that alternative investment opportunities be made available to those nearing normal retirement age. For ESOPs, the company must allow any employee who has attained age 55 with 10 years or more of participation to transfer at least 25% of their company stock assets to other more diversified holdings within the retirement plan over 5 years. In the sixth year, employees can shift another 25% of assets, for a total of at least 50%.

Options After Separation from the Employer

Determining what to do with shares of stock accumulated in an ESOP is often one of the most difficult decisions one faces upon leaving a company. Former employees are generally faced with three basic options:

 

  • liquidate the shares and withdraw the proceeds in a lump sum;
  • withdraw the shares in-kind from the ESOP and hold them directly;
  • make a direct transfer of the ESOP stock or sale proceeds to another qualified retirement plan, such as an IRA account.

Ascertaining which will be the most advantageous for any individual takes careful analysis in the areas of taxes, retirement and estate planning.

For additional information on this or related topics, or to learn more about the investment management and financial planning services offered by Bingham, Osborn & Scarborough, LLC, please visit our website at www.bosinvest.com.

Disclosure:

This white paper is for informational purposes only and is not intended to be used as a general guide to investing or financial planning, or as a source of any specific recommendations, and makes no implied or express recommendations concerning the manner in which any individual’s account should or would be handled, as appropriate strategies depend upon the individual’s objectives. It is the responsibility of any person or persons in possession of this material to inform himself or herself of, and to seek appropriate advice regarding, any investment or financial planning decisions, legal requirements, and taxation regulations which might be relevant to the topic of this white paper or the subscription, purchase, holding, exchange, redemption or disposal of any investments.

The portfolio risk management process includes an effort to monitor and manage risk, but does not imply low risk. Past performance is not indicative of future results, which may vary. The value of investments and the income derived from investments can go down as well as up. Future returns are not guaranteed, and a loss of principal may occur.

This white paper does not constitute a solicitation in any jurisdiction in which such a solicitation is unlawful or to any person to whom it is unlawful. Moreover, this white paper neither constitutes an offer to enter into an investment agreement with the recipient of this document nor an invitation to respond to the document by making an offer to enter into an investment agreement.

Opinions expressed are current opinions as of the date appearing in this material only and are subject to change. No part of this material may, without the prior written consent of Bingham, Osborn & Scarborough, LLC, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorized agent of the recipient.

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