Retirement Plans

What is an Employee Stock Ownership Plan - ESOP ?

An employee stock ownership plan, or ESOP for short, is a stock bonus plan that invests corporate profits back into the stock of sponsoring employer by rewarding employees with company stock.  An ESOP is a qualified plan and therefore, provides special tax benefits to the sponsoring employer, plan participants, and even the shareholder who sold the shares which were made available to the ESOP.

ESOPs are defined contribution plans which consist of a stock bonus plan or a hybrid which has a combination of a stock bonus plan and a money purchase pension plan. 

Employee stock ownership plans keep the employees focused on bettering the company and thus, becomes a win-win proposition for all parties involved.  

What are the Contribution Limits in an ESOP?

The ESOP is similar to a profit sharing plan or a money purchase pension plan in that it caps the employee benefit out at the lesser of the following two; 25% of their annual salary or $45,000.

When can I Withdraw the Funds in my ESOP?

In most cases, employer ESOP contributions vest 100% after 5 years.  This would mean that the employee would be able to sell 20% of the contribution every year for 5 years.

Alternatively, vesting can occur based on the number of years of employment with that company.  Some companies will mandate that the employee be with the firm for at least 3 years before vesting can begin.  Make sure you check with your HR resources to understand your entitlement.

If for some reason, you leave your employer before full vesting takes place, you will forfeit the unvested portion of your ESOP account.

What happens to my ESOP in the Unfortunate case of my Death?

In the case of an untimely death, the ESOP balance becomes 100% vested and withdrawal is allowed by the designated beneficiary that you set on the account.

What is the Fixed Amortization Method?

The fixed amortization method of determining substantially equal periodic payments is probably the most popular method out of the three available.  Its popularity stems from the fact that it is simple to calculate and also creates a wide ranges of possible annual payments.

The annual payment is derived by amortizing the account balance over a pre-determined number of years using the selected life expectancy table(uniform, single life, or joint and survivor) and interest rate that you choose.  Once the annual payment is determined for the first year, it stays fixed for the remainder of the plan.

Choosing the Appropriate Interest Rate

While you cannot just go and use any interest rate you want to, the rules around choosing one are fairly flexible.  The IRS states that you cannot use an interest rate that is over 120% of the federal midterm rate for the two months prior to taking the distribution.  Link to IRS Interest Rate Card.  Remember, that higher rates produce higher payments.

How do I Determine The Account Balance To Use?

The account balance part of the equation can be derived using the same rules as that of required minimum distributions.  You can either use the balance of your account from the last day of the prior year or you can use a date "within a reasonable period" prior to the distribution date.  The accout valuation on both of these dates could be drastically different if the market was swinging wildly in that time period.

Calculating Your Annual Payment

Calculating your fixed amortized payment is exactly the same as calculating your mortgage.  In our case, the mortgage balance is equal to our account balance.  The interest rate on the mortgage is equal to the interest rate we discussed above and the term of the mortgage (ie. 30 years) equates to our number of years from the life expectancy table.  The New York Life website has a great calculator which can easily help you determine this number. 

Advantages of Fixed Amortization Method

The advantages of using the fixed amortization method of determining substantially equal periodic payments is simple to use in the sense that you only calculate your annual payments 1 time and then that amount is the same every year.  Secondly, there is flexibility in the interest you use and thirdly, you are allowed to use any of the three life expectancy tables.  The name of this method should be flexible amortization.

Disadvantages of Fixed Amortization Method

The major drawback of this method is that the payment is constant.  Since it can only be calculated once, it will not take into account many items such as investment returns, changes to life expectancy, or items like inflation.  Just think of our current situation where inflation is going through the roof with these high gas and food costs.  Fixed amortization would not allow you to make adjustments to account for this.

What is Required Minimum Distribution?

The Required minimum distribution method is a simple way of calculating substantially equal periodic payments and is one that resets every year.  It is basically calculated by dividing your retirement account balance by your life expectancy factor as provided by the IRS grid. 

You will have three choices for a life expectancy factor.  You can either go with single life expectancy(no beneficiary), joint life expectancy, or the Uniform Lifetime table.  The latter two assume a beneficiary.  Remember, the longer you expect to have to pay benefits, the smaller your payments will be. 

How do I calculate the payment?

First you need to determine what your account balance is.  The IRS does not provide guidelines on this except by saying that the balance must be determined in a reasonable manner.  The most prudent thing to do here would be to use the balance of your account from the end of the prior tax year. 

Now that you have your balance, you will divide this by the life expectancy factor that you derived from one of the three life expectancy tables we mentioned above.  This is the amount you will receive in the first year.

This process must be repeated every year and be sure to only distribute the exact amount that you calculated.

Advantages of using Required Minimum Distributions Methodology

Being that you will be receiving an adjusted amount every year, this method allows you to actually withdraw an amount which takes into account your gains/losses from the prior year. 

Disadvantages of using Required Minimum Distributions Methodology

The drawback to using this method is probably obvious to you now.  Your distributions could swing drastically up and down as your investments fluctuate.  If you are looking for stable payments every year, this may not be the best option.  The nature of the life expectancy table renders smaller payments upfront and larger payments as you approach retirement.  This could be troubling for some of you as well. 

It is a big step to decide which form of computation you will be using to determing periodic payments; it is advisable to seek the help of a professional before you make the final move.

Miscellaneous Rules

Just a few other rules to know about when it comes to required minimum distributions.

• Instead of taking a yearly distribution, it is acceptable to take more regular withdrawals, such as monthly or quarterly as long as long as the distributions meet the required amount.
   
• If you have multiple IRA's in which you wish to take money from, you essentially are allowed to withdraw more money.  The IRS rule allows you to withdraw the total allowable aggegate amount from a single IRA.  For example, assume you can take $10,000 from three different IRA's, for a total of $30,000.  Essentially, you will be allowed to take $30,000 from a single IRA if you would prefer.
   
•  Individuals who withdraw more than the required minimum distribution for the year cannot use the excess as a credit fro the following year.  For example, if your required minimum distribution for last year was $2,000 and you withdrew $3,000; you must reduce your IRA balance from which you calculate RMD upon by $3,000.