Is ESOP diversification election applicable to 401(k) deferrals invested in employer stock?

[Guest Pennysaver]

Employer sponsors combined 401(k) profit sharing and employee stock ownership plan. Participants who wish to invest their 401(k) deferrals in employer stock have their 401(k) deferral amounts transferred from their Profit Sharing account within the plan to their ESOP account within the plan. Is the age 55/10 years of participation diversification election applicable to such amounts? Or would the distribution restrictions on 401(k) deferrals trump the diversification election?

[QDROphile]

Is the stock publicly traded?

[Guest Pennysaver]

Is the stock publicly traded?

No, it is not. I am asking about the diversification election required by IRC 401(a)(28), not the one required for publicly-traded employer securities pursuant to IRC 401(a)(35).

It seems to me that IRC 401(a)(28) would apply to the participant's account in the ESOP, regardless of the source of the assets in that account. But wouldn't there then be a problem due to the restrictions on distributions of 401(k) deferrals if the diversification election permits the distribution of employer stock purchased with 401(k) deferrals?

[QDROphile]

I was just curious about all the securities law violations that are occuring.

There is also a way to avoid the question with properly crafted diversification terms, and having publicly traded stock helps.

But I am going to be stinky and only offer that the plan seems to have a multiplicity of legal issues for which it needs some experienced and sophisticated professional help.

[ESOP Guy]

I agree with QDRO I would get some legal help that can make sure they understand all the facts and law. After 15 years of working with ESOPs I just have gotten very comfortable with the idea of getting the use of a lawyer for my clients. Too many ESOP questions seem to have gone unanswered in ways 401(k) plans don’t seem to have that problem. For what it is worth I have found many attorneys then taking the position that this silence means a lot of flexibility.

Having said that isn’t the safest answer to write the document such that 401(k) source diversifications have to be invested in the 401(k) plan? You have complied with the diversification law by allowing the person to sell the stock and invest it in the correct number of mutual funds. And you have preserved the 401(k) restrictions on in-service withdrawals.

I can’t quote a place that answers your question, but to me that is the safest answer. Otherwise you seem to be setting up a way to allow people to get around the 401(k) in-service distribution rules. Just put your 401(k) money in the ESOP and the next time we allow people to make diversification elections you can do an in-service distribution for a 55 year old in effect. And that seems like you are inviting the wrong kind of attention from the IRS. Sometimes trying to find these “loopholes” just aren’t worth it. You are being too clever for too little benefit.

[Guest Pennysaver]

Thanks to all who replied. I was wondering how the two requirements (diversification election and 401(k) distribution restrictions) operated together, and I appreciate the comments.