ESOP vs 401k: Which Is Better For Your Business?

ESOP plans offer a myriad of benefits for companies, employees, and selling owners alike. While we’d love to help every business out there promote employee ownership through an ESOP plan, we know they aren’t perfect for everyone.

That’s why comparing an ESOP with other retirement plans like a 401(k) is an important step in securing the wellbeing of your company and its employees.

Here’s the bottom line:

• An ESOP plan is the best option for those seeking to maximize employee retirement assets, promote inclusion in the workplace, and reap the benefits of employee ownership.
• A 401(k) is best if diversification of risk is your top priority. 

Below, we break down the benefits, risks, possibilities, and more that led us to each of those assessments.

Note: Rather talk to an expert than read a comparison? Email us to schedule a free consultation.

ESOP Plans: Turning Employees Into Owners

An employee stock option plan or “ESOP” is a popular way to give employees ownership stake in their company. They tend to yield higher returns and increase accessibility for younger and lower income employees especially, while also offering the tangential benefits of employee ownership.

It’s also important to note that an ESOP plan can be used alongside a traditional 401(k), with the latter being a secondaryplan. This is a solid strategy for mitigating risk, though it’s not always common practice (especially in newer ESOPs).

How does an ESOP work?

ESOP contributions are stored in a trust fund as shares of company stock. Vested employees receive their payout in the form of cash, stock shares, or both when they retire or leave the company. If there isn’t a public market for their shares, the company must buy them back at fair market value.

For greater detail, read our post “What Is an ESOP and How Does It Work?”

Who contributes to an ESOP?

Employers contribute to ESOP funds either in the form of new shares or cash to buy existing shares. That means that, unlike a 401(k), money does NOT come out of employee paychecks, increasing access for those who would otherwise not be able to defer their income.  

Employees can also contribute to the fund, though in reality, the vast majority of assets in an ESOP come from the company.

Who owns the shares in an ESOP?

ESOP assets are kept in a trust fund separate from personal or company accounts. While in the fund, they are overseen by a trustee who serves as the legal shareholder. Employer contributions to an ESOP become the property of an individual employee only after a certain vesting period is met.

Can an ESOP borrow money?

Yes. When an ESOP borrows money, it’s referred to as a leveraged ESOP. Practically speaking, more money means more shares that can be bought. The main reason for purchasing greater shares from the sponsoring company is for employees to hold a majority ownership stake or even buy out the company completely.

What’s the average rate of return on an ESOP?

Department of Labor data indicate ESOPs had a 9.1% annualized rate of return from 1990-2010 — compared to 7.8% in a 401(k) — according to the NCEO. In addition, employees at ESOP companies have 2.5x greater retirement accounts.

How risky is an ESOP?

In terms of volatility, ESOPs are typically less volatile than 401(k) plans. Additionally, what’s at risk is company money, not employee money. That’s because most ESOPs are funded entirely by the company, according to the NCEO. If the value of an ESOP sharply declines, that is a real loss — but “a very different kind of loss than would be the case in a 401(k) where most of the money came from the employees.”

Another concern some people have over ESOP plans is that they require employees to rely on the same company for both their paycheck and their retirement assets. However, many ESOP companies feature secondary plans, including traditional 401(k) plans, and diversify their assets over time.

What about taxes?

ESOPs are a kind of “qualified” retirement program, meaning that they qualify for federal income tax deferral until the stock is converted into cash. In other words, ESOP contributions continue to grow without being taxed until the money is taken out upon leaving the company.

From a company perspective, all employer contributions to the ESOP fund are tax-deductible and exempt from capital gains tax.

How do you set up an ESOP?

First, a company establishes a trust fund and either contributes new shares of stock or cash to buy existing shares. The shares get divided among eligible employees — often determined by a certain period of time worked — who then receive benefits according to the specific vesting schedule.

Other benefits of an ESOP

Employee ownership boasts many benefits in its own right. From productivity and firm performance to job security and satisfaction, ESOPs have something to offer everyone involved.

Read:  How Employee Ownership Helped Flyin’ Miata Preserve Its Culture and Legacy

401(k) Plans: A More Traditional Route

A 401(k) is the most common type of retirement plan in the United States, with nearly 60% of workers having access to one (but only 32% investing in them). They can be a powerful tool for improving your employees’ livelihoods, and the process of setting one up is relatively simple.

How does a 401(k) work?

In a 401(k), employees defer a portion of their income to be invested — typically in a diversified portfolio of mutual funds. Employers may or may not match employee contributions up to a certain limit. Money can be withdrawn at or after retirement, though it can also be withdrawn earlier in exchange for a 10% tax penalty.

Who contributes to a 401(k)?

For each enrolled employee, the majority of funds in a 401(k) are taken from their wages or salary: Money comes directly from the employee's pre-tax income with each paycheck. Usually, 401(k) plans also feature an employer match of 3-5%, though it isn’t required.

Who owns the funds in a 401(k)?

Money in a 401(k) is the lawful property of the employee, considering that most of the money aside from employer contributions came from withheld pre-tax income. 401(k) plans are managed by the company. After retirement, account balances are entirely owned and controlled by the employee.

How does leverage work in a 401(k)?

While “leveraged” ESOPs refer primarily to borrowing money to buy company shares, leveraging a 401(k) refers to taking a loan out of the fund in order to finance a real estate investment or down payment on a home. Any income generated from these investments is taxed as Unrelated Business Taxable Income (UBTI), though the loan itself is tax-exempt.

What’s the average rate of return on a 401(k)?

Department of Labor data indicate ESOPs had a 7.8% annualized rate of return from 1990-2010 — compared to 9.1% in a 401(k) — according to NCEO.

How risky is a 401(k)?

401(k) plans are generally well diversified, with retirement assets being distributed among multiple securities. Employees don’t have to depend on the same company for both their paychecks and their retirement accounts.

However, 401(k) plans tend to be more volatile, according to Department of Labor statistics reported by NCEO. And since most of the money in a 401(k) comes from employee paychecks, losses affect employees to a much greater extent.

What about taxes?

Like an ESOP, 401(k) plans are “qualified,” meaning that they qualify for federal income tax deferral until money is taken out of the account. In other words, money is taken from each paycheck before taxes, and it doesn’t become taxed until they are withdrawn. Employer contributions to 401(k) plans are also tax-deferred. 

How do you set up a 401(k)?

For small businesses, setting up a 401(k) is generally pretty straightforward. Simply shop around for plans and call a provider that best suits the needs of your specific business. The provider will then be able to help you with fund management, payroll integration, and more.

Disclaimer: We are not legal advisors. It’s always best to talk directly to a lawyer or 401(k) provider.

Conclusion

At a high level, ESOP plans and 401(k) plans can look pretty similar. However, the difference in benefits, risks, and possibilities for use are why we believe:

• An ESOP plan is the best option for those seeking to maximize employee retirement assets, promote inclusion in the workplace, and reap the benefits of employee ownership.
• A 401(k) is best if diversification of risk is your top priority. 

We’re confident that most small businesses — owners, employees, and customers alike — will thrive thanks to the benefits of an ESOP.

If that sounds like just what you’ve been looking for, let us help you take the next step.  Send us an email to schedule a free consultation.