How Does an ESOP Plan Work?
Learn how an ESOP works, how employees receive company stock, how ESOP shares are valued, diversification rules, and what happens to your ESOP when you retire or leave your employer.
By Michael Ruger, CFP®
Partner and Chief Investment Officer at Greenbush Financial Group
If you work for an employee-owned company, you may have heard the term ESOP when discussing your retirement benefits. But how does an ESOP plan actually work, how do you know what your company stock is worth, and what happens to your ESOP when you retire or leave the company?
An Employee Stock Ownership Plan (ESOP) is a qualified retirement plan designed to invest primarily in the stock of the company sponsoring the plan. Instead of simply receiving a traditional employer 401(k) contribution, employees participating in an ESOP can accumulate an ownership interest in the company where they work.
ESOPs are frequently associated with privately held businesses. Unlike shares of Apple, Microsoft, or other publicly traded companies, shares of a privately held ESOP company typically do not trade every day on a stock exchange. This creates some important differences when it comes to determining what your shares are worth and eventually turning those shares into cash.
For employees, an ESOP can potentially become a very valuable retirement benefit. But it can also create some unique financial planning questions.
In this article, we will explain:
How an ESOP works
Why business owners establish ESOPs
How employees receive company stock
Why an ESOP can potentially create significant wealth for long-term employees
How the value of privately held ESOP shares is determined
How an ESOP may work alongside a 401(k) plan
How the age 55 ESOP diversification rule works
What happens to your ESOP when you leave or retire
The tax consequences of taking an ESOP distribution versus completing a rollover
What Is an ESOP?
ESOP stands for Employee Stock Ownership Plan.
At its core, an ESOP is a retirement plan that gives employees an ownership interest in their employer. The plan holds company stock for the benefit of eligible employees, with shares or their value allocated among participants according to the terms of the plan. One of the most important things for employees to understand is that the ESOP owns the shares for your benefit through the retirement plan. You aren't normally receiving stock certificates that you can take home and sell whenever you want.
For example, assume you work for ABC Manufacturing, a privately held company with an ESOP.
Over the course of your employment, company stock may be allocated to your ESOP account. As you continue working for the company and satisfy its vesting requirements, more of that account becomes yours. If ABC Manufacturing grows substantially over the next 20 years, the value of those shares could potentially increase significantly. That's where an ESOP can become an extremely powerful retirement benefit.
Why Does a Company Sponsor an ESOP?
Why would the owners of a successful privately held company give employees an opportunity to become owners? There can be several reasons.
Succession Planning
Imagine that a business owner has spent 30 or 40 years building a successful company and is ready to retire. What happens to the business?
One option is to sell it to a competitor or private equity firm. Another is to pass it to family members. But those options aren't always attractive or available.
An ESOP can provide another potential exit strategy by allowing the owner to sell some or all of the company to an employee stock ownership plan. Instead of selling the company to an outside buyer, ownership can gradually transition to the employees who helped build the business.
Keeping the Company Independent
Owners may also establish an ESOP because they want the company to remain independent. Selling to an outside buyer could result in major changes to the company's culture, workforce, management team, or location. An ESOP can potentially provide a path for transitioning ownership while preserving the company's identity and operations.
Rewarding Employees
An ESOP also gives employees the opportunity to participate financially in the company's success. If employees help increase sales, improve profitability, control costs, and grow the company, those improvements may ultimately increase the value of the business and, consequently, the value of the ESOP shares. This can create a different relationship between the employee and the company. You're not just working for the company. You may also be an owner of the company.
Recruiting and Retaining Employees
A strong ESOP benefit can also be a valuable recruiting and retention tool. An employee who has accumulated a substantial vested ESOP balance may have another reason to build a long-term career with the company.
How Can an ESOP Create Wealth for Employees?
For employees, this is where ESOPs get exciting. A successful ESOP can potentially create life-changing retirement wealth, particularly for employees who spend many years working for a company whose value grows substantially.
We have a great example right here in New York's Capital Region: Stewart's Shops. Stewart's is a privately held, family- and employee-owned convenience store company. Employees own more than 40% of the company through its ESOP, which Stewart's refers to as "Profit Sharing." The ESOP is 100% employer funded.
The results for some longtime employees have been extraordinary. In April 2026, Stewart's reported that more than 200 participants in its ESOP had become millionaires. The company also reported that more than 3,400 partners were participating in the plan and that its 2026 company contribution was equal to 20% of eligible employees' annual salary.
Think about what that means. Someone could start working in a retail position, continue working for the company for many years, and gradually accumulate company stock through the ESOP. If the company continues to grow and the value of those shares appreciates, that ESOP balance can potentially become a significant retirement asset.
There is obviously no guarantee that every ESOP participant will become a millionaire. Company stock can increase or decrease in value, and benefits depend on the particular plan, years of service, compensation, vesting, company performance, and other factors. But Stewart's provides a real-world example of how employee ownership can potentially turn an ordinary job into an extraordinary wealth-building opportunity.
How Do You Know What Your ESOP Shares Are Worth?
This is one of the biggest differences between an ESOP at a privately held company and owning publicly traded stock. If you own 100 shares of a publicly traded company, you can pull out your phone and see approximately what those shares are worth right now. Private company stock is different. There isn't necessarily a buyer and seller agreeing on a price every second of the trading day.
Instead, ESOP shares of a closely held company generally need to be valued through a formal valuation process to determine their fair market value. For many ESOP participants, this means they may receive an updated account statement and share valuation once per year, rather than watching the price change every day.
Below is a hypothetical example:
In this hypothetical example, the employee's account is growing in two ways:
Additional shares are being allocated to the employee.
The value of the existing shares is increasing.
However, the reverse is also possible. If the company experiences financial difficulties and its valuation declines, the value of the employee's ESOP account can decline as well.
How Can an ESOP Work With a 401(k)?
Another area that frequently creates confusion is the relationship between an ESOP and a 401(k). They are not necessarily the same thing. A company can potentially maintain an ESOP and a separate 401(k) plan. The exact arrangement is determined by the employer's plan documents.
The employee are allowed to contribute their own pay each pay period to the 401(K) plan but the employer contribution may be made to the ESOP plan in the form of additional shares of the employer’s stock.
The Risk of Having Too Much Money in Company Stock
There is an important tradeoff to ESOP ownership. If your company performs extremely well, owning a large amount of company stock can create substantial wealth. But it also creates concentration risk.
Imagine that you're 58 years old and have:
$100,000 in your 401(k)
$50,000 in an IRA
$1,200,000 in your company's ESOP
Most of your retirement wealth is tied to one company. But there's another issue. Your paycheck also comes from that same company. If the company experiences financial trouble, you could potentially face two problems simultaneously: Your job may be at risk, and your largest retirement asset may decline in value.
That is one of the reasons diversification becomes an important financial planning conversation for longtime ESOP participants.
How Does the Age 55 ESOP Diversification Rule Work?
Federal tax law provides certain longtime ESOP participants with an opportunity to diversify a portion of their company stock. People frequently refer to this as the age 55 diversification rule, but age isn't the only requirement.
Generally, a qualified participant must:
Be at least age 55, and
Have completed at least 10 years of participation in the ESOP
Under the applicable rules, participants generally must be allowed to diversify up to 25% of qualifying employer securities during the first five years of the election period. During the final election year, that percentage generally increases to 50%, subject to the detailed rules governing the calculation.
For example, if an employee is age 55 and worked for the company for 20 years, they would be allowed to distribute or rollover 25% of their balance in the ESOP plan in the year that they turn age 55. In the 6th year, when the employee turns age 60, the amount eligible for diversification increases from 25% to 50% of the vested account balance in the ESOP.
Why does this rule exist? Because someone approaching retirement may have accumulated a very large percentage of their retirement assets in one privately held company. Diversification gives that employee an opportunity to begin reducing that concentration.
Should You Roll Your ESOP Diversification Money Into an IRA?
If your plan permits an eligible diversification distribution, one potential strategy may be a direct rollover to a Traditional IRA. Depending on the plan structure, another possibility may be moving the diversified amount into investment alternatives available through another qualified plan, such as the employer's 401(k). Why might someone do this?
Suppose you have $800,000 in company stock and become eligible to diversify $200,000.
Instead of taking $200,000 in cash and potentially creating a current tax liability, an eligible amount might be directly rolled into a Traditional IRA. Inside the IRA, you could potentially invest across:
U.S. stocks
International stocks
Bonds
Mutual funds
ETFs
Other investments
You have now taken part of a concentrated position and spread it across many different investments. A properly completed direct rollover of an eligible retirement-plan distribution to a Traditional IRA generally does not create current income tax on the amount rolled over.
However, employees should be careful about automatically moving ESOP assets into an IRA without evaluating the alternatives. Investment choices, fees, creditor protections, withdrawal rules, the age-55 penalty exception, and other factors can differ between an employer plan and an IRA.
What Happens to Your ESOP When You Leave the Company?
This is another common question. You generally don't lose your vested ESOP balance simply because you retire or change employers. However, leaving the company does not necessarily mean you receive a check immediately.
Your distribution timing and available options are controlled by the ESOP's plan documents and applicable federal rules. Depending on the plan, benefits may ultimately be distributed as a lump sum, installments, or through another permitted method. This makes the company's Summary Plan Description extremely important.
Before retiring or changing jobs, find out:
How much of your account is vested?
When are you eligible to begin distributions?
Are payments made immediately or delayed?
Is your benefit paid as a lump sum or installments?
Can you complete a direct rollover?
What happens to the company shares when you leave?
Are there special provisions for retirement, disability, or death?
Don't assume your ESOP works exactly like another company's ESOP.
What Are Your ESOP Withdrawal Options?
Once you become eligible for a distribution, there are several potential paths. The availability of each option depends on your plan.
Option 1: Take the Money in Cash
You may be able to receive some or all of your vested ESOP benefit as a cash distribution. The downside is taxes. Because an ESOP is generally a tax-qualified retirement plan, previously untaxed amounts distributed to you are generally subject to ordinary income tax unless they're rolled over or another special tax treatment applies.
If you're under age 59½, the taxable amount may also be subject to a 10% additional early-distribution tax unless an exception applies.
For example, assume a 50-year-old leaves an ESOP company and receives a taxable $200,000 cash distribution without rolling it over.
That $200,000 could be included in taxable income, and the employee could potentially face the additional 10% early-distribution tax unless an exception applies. That can create a very expensive tax year.
Option 2: Direct Rollover to a Traditional IRA
Another common option for an eligible distribution is a direct rollover to a Traditional IRA.
If $200,000 moves directly from the ESOP to a Traditional IRA, there is generally no current federal income tax on that rollover. The money remains tax-deferred. Taxes are generally paid later when taxable distributions are taken from the Traditional IRA. This can also provide an opportunity to diversify away from company stock and build an investment portfolio appropriate for your retirement goals.
Option 3: Roll the Money Into Another Employer Plan
If your new employer's qualified retirement plan accepts incoming rollovers, you may be able to roll an eligible ESOP distribution into that plan. This can be attractive for someone who wants to consolidate retirement accounts. Again, a qualifying direct rollover generally avoids current taxation.
Option 4: Take Some Cash and Roll Over the Rest
Depending on the distribution and plan rules, you may be able to roll over part of an eligible distribution and receive part in cash.
For example:
ESOP distribution: $500,000
Direct rollover to IRA: $450,000
Cash distribution: $50,000
The $450,000 direct rollover would generally continue to be tax-deferred, while the taxable $50,000 cash portion would generally be included in income and could potentially be subject to the 10% additional early-distribution tax if applicable.
Be Careful With the Age-55 Rule When Rolling an ESOP Into an IRA
There is an important tax-planning issue that is easy to overlook. Qualified employer retirement plans have a special exception to the 10% early-distribution tax for certain employees who separate from service during or after the calendar year in which they reach age 55. Traditional IRAs do not have that same separation-from-service-at-55 exception.
Consider someone who retires from an ESOP company at age 56 and needs $40,000 per year from the account until reaching age 59½. If the money remains eligible for distributions under the employer's qualified plan, the age-55 separation exception could potentially allow those qualifying distributions without the additional 10% early-distribution tax. If that employee first rolls the entire balance into a Traditional IRA, however, the IRA generally uses the age 59½ standard unless another IRA exception applies.
That doesn't mean you should never roll an ESOP into an IRA. It means the timing of the rollover matters. For someone retiring between ages 55 and 59½, this should be reviewed carefully before moving the entire account.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
Frequently Asked Questions About ESOP Plans
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What is an ESOP and how does it work?An ESOP, or Employee Stock Ownership Plan, is a qualified retirement plan designed to invest primarily in the stock of the sponsoring employer. Eligible employees can accumulate an ownership interest in their company through shares or value allocated to their ESOP accounts. Employees generally receive the value of their vested benefits when they become eligible for distributions under the plan.
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Do employees have to pay for ESOP shares?Frequently, employees do not directly purchase the ESOP shares with money from their paychecks. The company generally funds the ESOP, although the exact structure varies by employer. Employees should review their Summary Plan Description to understand how their particular ESOP is funded and how shares are allocated.
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How do I know how much my ESOP is worth?If your employer is privately held, its stock generally doesn't have a publicly quoted daily market price. A formal valuation process is used to determine fair market value. Participants generally receive account statements showing their shares or account value, vested balance, and changes in value.
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Can ESOP stock lose value?Yes. An ESOP is not guaranteed to increase in value. If the company's financial condition, profitability, growth outlook, industry, or other valuation factors deteriorate, the company's appraised share value may decline. This is one reason diversification can become important for employees with large ESOP balances.
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What happens to my ESOP if I quit my job?Your vested ESOP benefit generally remains yours when you leave the company, but you may not necessarily receive the money immediately. The timing and form of your distribution depend on the terms of the ESOP and applicable law. Any unvested portion may potentially be forfeited according to the plan's vesting rules.
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Can I roll my ESOP into an IRA?Eligible ESOP distributions can generally be rolled directly into a Traditional IRA, allowing the retirement assets to continue growing tax-deferred without creating current income tax on the amount properly rolled over. A rollover can also provide an opportunity to diversify away from concentrated employer stock.
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At what age can I diversify my ESOP?For the special statutory ESOP diversification rules, a qualified participant generally must be at least 55 years old and have at least 10 years of participation in the plan. The diversification election period then generally extends for six plan years, with applicable diversification percentages governed by federal law and the plan's provisions.
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Do I pay taxes when I withdraw money from an ESOP?Generally, previously untaxed ESOP distributions that are paid to you rather than rolled over are subject to ordinary income tax. If you receive a taxable distribution before age 59 1/2, a 10% additional early-distribution tax may also apply unless you qualify for an exception. A properly completed direct rollover to a Traditional IRA or eligible retirement plan generally defers the income tax.
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Is an ESOP better than a 401(k)?Neither is automatically better. They serve different purposes and can complement each other. A 401(k) typically allows employees to make payroll contributions and invest across multiple investment options. An ESOP primarily invests in employer stock and is often funded by the employer. Having access to both can potentially provide the benefits of company ownership along with a more diversified retirement account.
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Can an ESOP make you a millionaire?It can, but there are no guarantees. Employees who work for a successful ESOP company for many years may accumulate substantial retirement wealth through employer contributions, additional share allocations, and appreciation in company value. The outcome for any individual employee depends on the company's performance, plan provisions, compensation, years of participation, vesting, and other factors.
