Employee Stock Ownership & Stock Options

What You Need to Know About an Employee Stock Option Plan

An employee stock option plan is important to consider in addition to a company's 401K plan in order to help save for retirement. Exact amounts vary, but one of the core principles in a 401K plan is that the employee will contribute a small percentage of their income into their retirement fund that includes a mixture of stocks, bonds, and mutual funds, and the company will match a portion, if not all, the contributions made into the fund. While many people once believed these contributions were sufficient for employee retirement, many are also looking at employee stock ownership as a worthy investment for their future.

Once upon a time, stock options were primarily offered exclusively to executive management, but increasingly the general staff are also given the opportunity to take part in an Employee Stock Ownership Plan (ESOP) in order to make a little extra money. When a company offers this, they write up a subscription agreement that specifies the conditions of the stock purchase. Often, it is explained to employees as profit sharing and is presented as part of an employee benefits package.

Employee ownership can be a good way to experience stock ownership outside of a 401K plan or the traditional stock market because the subscription agreement will normally include a stock incentive that goes along with the purchase of stock. One example is an employer may guarantee a lump sum of money after an employee has held onto their stock purchase for a certain amount of time. Another possibility it that you may be guaranteed a certain price on your stock purchase for a period of time, even if the price goes down in the market.

While this all sounds like a great deal, and it often is, it can be expensive to make that initial investment. Some companies require a lump sum, although many simply set up a payroll deduction when they really want to encourage widespread employee ownership. It is also important that the funds you invest in the option plan are taxable, unlike other money in your employee retirement account. Depending on your personal tax situation, you may want to consult with a tax advisor on whether the stock incentive will be cost effective on its own or whether you should consider transferring the stock to a more tax-friendly account, such as an IRA or your child's college fund.

Taxwise, many prefer an ESOP that is an incentive stock option or ISO. The stock incentive is that the income from the stock is not taxed as long as you hold onto the stock. Once you sell, however, all profits are taxed at that time. You can limit the amount of tax owned by holding the stock for at least two years. This way your profits are taxed at the long-term capital gains tax rate, which is lower than normal income taxes. Many times ISOs are offered only to management or even executives, and these can't be discounted or transferred except through a will. For some, the discount offered by their employer's plan makes a non-qualified stock purchase worth it, even without the potential tax benefits.