Which is better, ESOP or 401k retirement plan?

Probably the most common types of employee benefit plans are Employee Stock Option Plans (ESOPs) and 401(k) retirement plans. The primary purpose of these plans is to provide benefits to employees in the form of company stock or retirement funds. However, ESOPs and 401(k) retirement plans differ in structure, taxation, costs, process, and other features. Therefore, it is necessary to understand the differences between ESOPs and 401(k) retirement plans in order to choose the right type of plan for employees. This article will compare various aspects of ESOPs and 401(k) retirement plans to help you make the right choice.

ESOP and 401(k) retirement plan

These plans are basically designed to offer benefits to employees. But, why should the employer offer benefits to the employee? Well, ESOPs and 401(k) retirement plans provide financial security to employees, increase motivation, improve employee retention, and enhance employee job satisfaction. As a result, employees become more productive and contribute to the company's success. However, you might wonder, what makes 401(k) retirement plans and ESOPs different? In the following section, we will discuss the concept of ESOPs and 401(k) retirement plans and further compare the two.

What is an ESOP?

Employee stock ownership plan or ESOP is a kind of stock-based compensation that enables employees to purchase shares of the company they work for. In this arrangement, the company offers a specific number of stock to employees at a predetermined price after a particular period of time. The objective of this plan is to provide employees with a means of obtaining ownership, thus enabling them to participate in the growth of the company. This results in increased motivation and employee retention. Therefore, ESOPs aim to improve productivity, boost morale, and reduce turnover.

How does ESOP work?

ESOP is a long-term plan in which employees purchase the company's stock. Similar to stock options in private companies, the employee under ESOP has the opportunity to acquire shares of the company at a particular price within a certain period of time. 409A valuation is used in private companies to determine the fair market value (FMV) of the common share based on which the ESOPs are priced.

The predetermined price at which ESOP shares are granted to employees is called the strike or exercise price. While there is a particular duration during which employees must hold the shares of an ESOP, known as the vesting period. The employee can purchase the shares after the vesting period is completed at the strike price. Thus, ESOPs are identical to stock options in private companies in terms of structure. However, the purpose is different.

Features/Benefits of ESOP

Now that we have discussed ESOPs in brief let us take a look at the benefits of ESOPs. Here are a few of the benefits of ESOPs:

1. Ownership stake of the company - The sense of ownership among employees helps to enhance employee satisfaction, motivation and productivity. In fact, employees have a vested interest in the company and are more likely to contribute to the organisation's growth.

2. Reduced worker turnover - Employee retention is always beneficial for both employees and employers. Therefore, when a company provides a means for employees to seek financial security during their working life, it helps to reduce turnover and increases morale and employee dedication resulting in a better workplace environment.

3. Top talent acquisition - By providing an opportunity for employees to obtain ownership and seek financial security under ESOP, the company stands a better chance of hiring talented and loyal employees. Moreover, providing ESOPs also generates positive publicity among prospective candidates.

What are the drawbacks of ESOPs?

The following are some of the disadvantages of ESOPs:

1. Taxable events - Under the ESOP program, there are two taxable events for employees. The first event occurs at the time of exercising the ESOP; when employees receive shares under the ESOP program, it is considered ordinary income tax. The second event occurs at the time of sale; when employees sell their shares, they will have to pay capital gains taxes on the profit.

2. Dilution - In order to provide ESOPs to all its eligible employees, a company has to issue additional shares and dilute ownership among existing shareholders. The equity dilution of existing stockholders to provide ESOPs could potentially reduce their ownership stake in the company and, thus, the value of their investment.

3. Cost - Employees must have sufficient funds to make the purchase of shares under ESOP. ESOP plans might prove to be costly; they involve additional costs such as administrative fees, legal costs, and other expenses involved in the program. As a result, ESOP financing might outweigh the benefit to employees.

What is a 401(k) Retirement Plan?

A 401(k) retirement plan is a retirement savings plan that allows employees to allocate some of their salaries or pay into an account that is based on investments. 401(k) plan is named after the United States Internal Revenue Code (IRC) and was designed to help employees save for retirement. It is a tax-deferred savings plan which aims at providing employees with a more secure future, encouraging job retention, and promoting employee loyalty to the company. Introduced in 1978, the 401(k) retirement plan is the most popular employee benefit plan in the US and thereby is an effective tool for employees to achieve financial security.

How does a 401(k) Retirement Plan work?

In a 401(k) plan, the employer is known as the plan sponsor, wherein a particular percentage of the employee's salary is invested into a retirement account. The money contributed to the account by employees is deducted from the paycheck before taxes, reducing taxable income. Furthermore, the money accumulated from contributions is generally invested in mutual funds and other investment products available in the market. After reaching a certain age, employees have the option to withdraw the money from their account at any time by paying certain taxes. As such, 401(k) retirement plans allow employees to save for their retirement needs.

Features/Benefits of a 401(k) Retirement Plan

You have now learned some basic information about 401(k) plans. The following is a list of some of the benefits associated with 401(k) plans:

1. Retirement planning - A 401(k) plan can be an effective tool in helping employees reach their retirement goals. 401(k) plans offer a wide range of investment opportunities, thereby increasing the potential for earning higher returns. Overall, 401(k) plans offer a secure future for employees.

2. Tax-deferred contributions - Under 401(k) plans, employees' contributions are deducted from their paychecks before taxes, which means that they reduce the employees' taxable income. Typically, it lowers the income tax burden for employees, thereby helping them save more.

3. Compounding - You might have heard the term "compounding" before; it refers to the continuous process of earning interest on one's existing investment. Under 401(k) retirement plans, the total amount of contribution from employees will accumulate over time, and therefore, it is possible for employees to earn more money in their retirement account.

What are the drawbacks of a 401(k) Retirement Plan?

The following are some of the drawbacks associated with 401(k) plans:

1. Withdrawal restriction- Under 401(k) plans, there is a certain period after which employees have the option to withdraw the money from their account. Generally, after 60 years of age, employees can withdraw their money. However, if the money is withdrawn before reaching the age of 59.5 years, it is considered a taxable event, and the employee will have to pay a 10% penalty on the amount withdrawn.

2. Lack of flexibility - Regardless of the market conditions, employees are required to make fixed contributions. This means that they cannot control the amount of money they contribute to their accounts; rather, they have to abide by the fixed contribution every month. As such, 401(k) plans generally do not give much flexibility.

3. High fees - Generally, there are certain fees associated with 401(k) retirement plans due to the fact that 401(k) is high regulation. These fees are known as administrative expenses, and therefore the plan participant will be required to pay a certain amount of fees on a regular basis.

ESOP vs. 401(k) Retirement Plan

Now that you have learned about 401(k) and ESOP, which of the two programs is better? When it comes to choosing between an ESOP plan and a 401(k) plan, it ultimately comes down to each employee's preference. Certain employees consider ESOPs as the best employee benefit, whereas others view 401(k) plans as more beneficial. Below are some of the differences between ESOP and 401(k) retirement plans:

1. Contribution level - 401(k) retirement plans have a set process in terms of how contributions are made, generally that they are fixed contributions, regardless of the economic situation. On the other hand, with ESOPs, the employee has the right but not the obligation to exercise and purchase the shares. Hence, this means that in terms of contribution level, ESOPs are better than 401(k) retirement plans.

2. Duration of the plan - As mentioned above, 401(k) retirement plans have a set period after which the employee will be able to withdraw the money from their account, generally at the age of 59.5 years. While ESOPs do have a vesting period, however, it is shorter than that of 401(k) retirement plans. After the employee exercises the right to buy the company shares, they can sell them anytime. In terms of the plan duration, ESOPs are better than 401(k) retirement plans, although this depends on the personal preferences of each employee.

3. Risk/return relationship - 401(k) retirement plans offer employees a relatively low risk and relatively high return. Usually, the funds of a 401(k) plan are invested in mutual funds, considered a relatively low-risk investment. In contrast, ESOPs generally offer employees a high-risk and high-reward relationship. However, in privately held companies, the FMV of shares is not volatile. Still, this does not mean that ESOPs are not risky. As a result, in terms of the relationship between risk and return, 401(k) plans are better than ESOPs.

Which one is the right choice?

Well, choosing between a 401(k) plan and an ESOP is an individual decision because the two plans do have their own advantages and disadvantages. Depending on the risk appetite, financial condition, future planning, personal preferences and other considerations of the employee, it is up to the employee to make the right decision. There is no such best option for employees, it all depends on various factors. Both ESOPs and 401(k) plans are a great way of helping employees, however, in terms of making the right choice, it is ultimately up to each employee.

Conclusion

Fortunately, you have now gained a clear understanding of the 401(k) retirement plan and ESOP as well as their differences. However, from an employer's perspective, setting and managing these two programs is not easy. By hiring a third-party service provider like Eqvista, you will be able to effectively manage both the 401(k) plan and the ESOPs. At Eqvista, we are committed to helping employers set up, manage, and administer their 401(k) plans and ESOPs. We have a team of dedicated professionals that can help you make your company's 401(k) plans and ESOPs a success. For more details, get in touch with us today.