What to know before you sign your distribution paperwork
If you've worked at a company with an ESOP, you may have a retirement account that is a significant part of your savings. ESOPs or Employee Stock Ownership Plans are a type of employer sponsored retirement plan that gives workers an ownership stake in the company. When the company is sold, that account usually gets paid out or moved. The choices you make in the next few weeks can change how much of it you keep, and they can be hard to undo.
What is going to happen to my account?
When a company is sold, your ESOP shares are typically converted to cash, and you'll be asked how you want to receive it. In general, you can:
- Take the cash. You get the money now, but it's taxed as regular income, federally and often by your state. Taxes are withheld at payout, and the amount withheld may not match what you actually owe. If you're under 59½, there can also be a 10% federal penalty and a state penalty.
- Roll it into an IRA. The money can remain invested and tax-deferred, and we can work with you on how it's invested. In our experience, this is often a core part of the plan. Taxes are deferred at the time of rollover.
- Do some of each. For some people, this turns out to be a reasonable compromise.
Can I get at my money if I'm not 59½ yet?
Often, yes, and in our experience, this is where people make costly income tax mistakes.
If you leave your employer in or after the year you turn 55, you can usually take money out of the plan without the 10% penalty. But once the money goes into an IRA, that special exception disappears. Rolling everything over automatically could lock up money you need.
If you're not yet 55, or the money is already in an IRA, there's another route. A schedule of regular payments from an IRA, called a 72(t), generally lets you take money penalty-free. The catch is that the schedule is rigid and must continue for at least five years or until 59½, whichever is longer. We can set it up on a portion of your account, sized to what you actually need.
Can this replace my paycheck?
It may be possible. Instead of one big payout, you can set up regular distributions that work like a paycheck while the rest of your money stays invested. We'll line it up with any severance pay and Social Security, for example.
Will this make my taxes or Medicare costs go up?
It can, and in our experience, many people don’t anticipate it. A big distribution can have ripple effects.
- Social Security taxes. Depending on your other income, up to 85% of your Social Security benefit can become federally taxable.
- Medicare premiums. Higher income can trigger extra Medicare charges, called IRMAA. The surprise is that Medicare looks back two years, so what you do this year affects your premiums later.
- Withholding. The amount withheld at payout, for federal and state taxes, may be too little or too much. We can help you plan for withholding so you’re better prepared at tax time.
The goal is to plan for taxes and reduce surprises.
Is there a smart time to pay taxes early?
Sometimes. Many people have a few lower income years between leaving work and starting Social Security. Those years can be a chance to move money from your IRA into a Roth IRA, called a Roth conversion. You pay tax now, potentially at a lower rate, and qualified withdrawals from the Roth IRA are tax free. A Roth IRA also isn’t subject to required withdrawals during the owner’s lifetime, and it can be a tax-efficient account to leave to your family.
In those same lower income years, you may be able to sell investments outside your retirement accounts and pay little to no federal capital gains tax. How much room you have depends on your income that year, and we work that out with you.
What if most of my money is in one company's stock?
That's common with an ESOP, and it's risky. In an IRA, you can spread your money across many investments without paying tax each time you change something. In our experience, that flexibility can be a significant benefit of rolling over, though similar flexibility may be available in other options, depending on the plan’s investment menu.
What else should I know?
- Protection from creditors. Retirement accounts generally get strong legal protection, but the rules vary by account type. We'll explain what applies to you.
- Required withdrawals. At a certain age, the government makes you start taking money out of pre-tax accounts. Planning ahead can keep those withdrawals smaller.
- Giving to charity. After 70½, you can send money directly from your IRA to charity. It counts toward your required withdrawal and isn't taxed, even if you don't itemize your deductions.
- If you receive company stock instead of cash. There's a special tax rule that may reduce taxes in some cases, but it has strict deadlines and may not apply. Ask before you sign.
Why talk to us?
We're a family-run firm of both CPAs and financial advisors, and our team has decades of combined experience, including helping people through major financial events tied to their employer. Because we offer both tax and investing services, we can look at the whole picture.
If your company is going through a sale, talk to us before you sign the paperwork.