A rollover takes place when an employee stock ownership plan (ESOP) participant withdraws cash or assets from the plan and contributes that wealth within 60 days to another eligible retirement plan. Rollovers from one qualified plan to another are generally not taxable, but a rollover from a pre-tax plan to a Roth IRA (or another Roth account) is taxable and reportable on the participant’s federal income tax return.
As a qualified plan, an ESOP is tax-deferred until participants receive distributions on their accounts. A traditional IRA is also tax-deferred, so as long as the rollover takes place within 60 days of the distribution, the participant will continue to defer taxation on the account balance.
But a Roth IRA uses after-tax dollars, so when employees choose to roll the value of some or all of their allocated ESOP account shares to a Roth IRA, they owe taxes on the value of their shares, requiring reporting treatment that is similar to filing a 1099-R for IRA to Roth conversion code.
Because the rollover to a Roth IRA is a distribution, it must be reported as income on IRS Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. The payer, trustee, or plan administrator must file the Form 1099-R and furnish a statement to the recipient.
It’s important to ensure that rollovers are accurately and correctly reported, so let’s take a closer look.
Why Would an Employee Request a Rollover from an ESOP to a Roth IRA?
Why would an ESOP participant choose to rollover to a Roth IRA? They may decide that the advantages like tax-free withdrawals in retirement and no required minimum distributions are worth the up-front taxes owed. Typically, a participant would wait until age 59-½ to avoid an extra 10% tax penalty on an ESOP distribution (more details on this below).
By and large, ESOP distributions take place after the participating employee separates from employment. But in some cases, participants can receive distributions from their ESOP accounts while still employed. These situations include:
- Participants who wish to diversify their retirement savings (and meet requirements)
- Participants over age 72 who own 5% or more of company shares
- Direct payments of company stock dividends by the employer
- Other specific circumstances outlined in the plan design (minimum years of service, attainment of a specified age, or hardship distribution, for example)
A few key issues involved in a Roth rollover include:
Eligibility of the rollover distribution. According to IRS instructions for Form 1099-R, “An eligible rollover distribution is any distribution of all or any portion of the balance to the credit of the employee (including net unrealized appreciation (NUA)) from a qualified plan.” Some eligibility exceptions include required minimum distributions (RMDs) and prohibited allocations of S corporation securities that are treated as deemed distributions.
Employee age. Distributions taken before employees reach age 59-½ are considered “early” or “premature,” and are therefore subject to an additional 10% tax. If employment has been terminated, the minimum age to avoid the additional 10% tax penalty is 55.
Hardship. Withdrawals or loans due to hardship may not be subject to the additional 10% tax. That said, most ESOPs intentionally proscribe loans or hardship withdrawals in the plan design and documents. This makes sense, since company stock is relatively illiquid compared with cash or other asset types.
Rollovers from ESOPs to IRAs Can Be Complex
The procedures involved in executing a rollover can be complex, and can have tax implications for plan participants, so it’s essential to consult with your financial and/or tax professional to determine the best process for converting the funds and reporting on 1099-R forms.
An ESOP’s 1099-R filings are typically among the tasks addressed by administrators in January—a month filled with forms, filings, and requirements. Make it easier to plan ahead for your ESOP’s complex and time-sensitive regulatory and administrative requirements with our free month-by-month administrative planning calendar. Click the link below to get yours today.