Employees who participate in an employee ownership plan do not pay tax on the stock that has been allocated to their accounts until they receive payouts. They are taxed on their ESOP distributions (sometimes known as "cashing out" an ESOP in simple language).
ESOP payouts received by workers under the age of 59-12 (or, in the case of ending employment, under the age of 55) are deemed early withdrawals and are subject to usual applicable taxes plus a 10% excise tax. This extra tax is known as a penalty tax on ESOP payouts. The ESOP dividend is not subject to the extra 10% employee ownership plan distribution tax penalty if the participant's employment ended due to death or incapacity.
This extra excise tax can be eliminated by rolling over the ESOP account balance into a regular or Roth Individual Retirement Arrangement (IRA), or into a retirement savings plan with a new employer, such as a 401(k). The rollover option postpones income taxes on the ESOP payment, and payout recipients normally have 60 days to complete the ESOP rollover into an IRA. The terms of the plan into which the funds have been rolled over apply to the funds.
A Roth conversion is similar in that the distributions are taxable as ordinary income (not subject to the 10% excise tax) and are carried over into a Roth IRA, where the assets can grow tax-free.
Dividends paid directly to participants by an employee ownership plan are not subject to the excise tax on early payouts. They are likewise free from withholding on income taxes, but dividend payments are fully taxable.
When an ESOP distributes actual shares of company stock rather than cash, the employee paid tax at conventional tax rates on the value of direct donations to the plan, as well as capital gains tax on share value development because they choose to recoup their investment.
When participants receive $10 or more in employee ownership plan payments, the ESOP custodian or third-party administrator (TPA) must produce and file Forms 1099-R and 945 for ESOP taxation filing.
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