If you are a high earner, opting into your company’s employee stock purchase plan (ESPP) can be exciting. You may have dollar signs in your eyes at the thought of an ESPP magically putting extra cash in your pocket.
But it’s not quite that simple. While entering into your company’s employee stock purchase plan can be lucrative under the right circumstances, there are also tax implications that could have a big impact on your bottom line if not executed properly.
At Plancorp, we’ve helped hundreds of clients successfully manage their equity compensation for more than 40 years. We understand the complexities and what strategies can supercharge these benefits and set you up for success.
Below we’ll cover key management strategies to consider if you hope to reap the biggest possible benefits.
An employee stock purchase plan is a company benefit that allows employees to buy company shares at a discounted rate, oftentimes as high as 15% off the current stock price.
They are typically offered as an employee incentive and give employees the opportunity to gain from company growth.
Of the four types of equity compensation, ESPPs are one of the most common forms employers offer. Learn more about other types of equity compensation here.
When an employee enrolls in an ESPP, they choose a contribution percentage to be added to the plan through regular payroll deductions, i.e. 5% of their gross pay. You can contribute up to $25,000 in a tax year, giving high earners big growth potential.
After a period of time, known as the offering period or enrollment period, the employer uses the accumulated ESPP contributions to purchase shares of company stock at a discounted price based off the current fair market value.
The employee then owns the shares until they decide to sell, which can be at any point during the process. How long an employee chooses to hold ownership of the stock will affect the eventual tax benefits—or tax burdens.
If you’re unfamiliar with the stock market or how ESPPs work, we understand why you may have trouble deciding if this option is right for you. Here are several reasons you should consider enrolling in your company’s ESPP.
You get to own company stock at a discounted purchase price, which already saves you money.
ESPPs give you more “skin in the game” by allowing you to participate in, and hopefully benefit from, the growth of your company.
They can be a great way to build wealth, if managed strategically.
ESPPs can help you reach both short-term and long-term financial goals, depending on when you sell.
You don’t lose the stock if you quit your job.
You can sell at any point; just be aware of tax implications.
Here are a few strategies for finding success with your ESPP.
It’s never a good idea to put all of your eggs in one basket, especially when market volatility is part of the equation. If you put all your money into your company stock and your company goes bust, you lose your nest egg.
A better idea is to diversify your stock. This means spreading out your money among multiple companies or investing in broadly diversified funds.
You want to avoid having a major portion of your stock portfolio relying on the fortune of any single investment.
Typically, we recommend keeping your company stock allocations under 10% of your total net worth.
A stock management plan is a framework for making decisions based on the company stock you have now and grants you receive in the future.
With an ESPP, your stock management plan will include a few key decisions:
Do you sell right away or hang onto the stock and use it for long-term goals?
If you sell, are you diversifying into other investments or moving to cash?
How you choose to manage these decisions will likely be based off the details of your plan, i.e. does your ESPP plan have a lookback provision, and have you held the stock long enough for a qualifying disposition? More on those details here.
Sticking to a plan will allow logic and reason to reign rather than any emotions you may have about your company and its performance.
A plan will also give you direction and keep you on the path toward your goals and alleviate any anxiety about investing by reducing indecision and increasing confidence.
With an ESPP, you can sell stock fairly quickly after purchase. This is a great way to cash flow your short-term goals.
If you are continuously putting money into an ESPP account when purchase periods open, and you sell your stock from the previous purchase date, you could have a big chunk of cash coming your way every few months.
Let’s look at an example to understand how:
Say your discounted rate is 10%. You contribute the yearly limit of $25,000 over the course of two 6-month enrollment periods, maxing out your yearly contribution. The market price of your company stock is on each purchase date $50, meaning your share price will be $45.
Your $25,000 buys you 555 shares of your company stock, give or take. If you then turn around and sell those 555 shares at the market price of $50, you’re pocketing $27,778, which is $2,777 extra!
Keep in mind, though, it’s not totally “free money”—if you sell right away, that $2,777 will be subject to ordinary income tax rates.
While there is quite a bit of nuance here that a wealth management pro can walk you through, holding ESPP stock for more than two years after the offering date and one year after the purchase date will often result in the most favorable tax outcome.
However, this should not be the only (or even primary) consideration when deciding to hold or sell. There’s no telling how the stock position will perform between now and then.
It’s important that you consider your ESPP in your tax planning strategy. While it's common to only sell ESPP shares, it can be difficult to understand how to do this.
Before you sell your shares, you will need to determine whether there is a benefit to recognizing the income this year, or if it’s better to wait.
The potential tax treatment, especially if your income is nearing the top of a tax bracket, is what can complicate your employee stock purchase plan.
Whether you’re in a state of a qualifying or a disqualifying disposition will affect if the earning are classified as ordinary income or if they’re subject to capital gains tax. How long you’ve held the stock can also affect whether those gains are taxed as short-term capital gains or will be hit with a long-term capital gains rate.
Every situation is different and working with a trusted financial advisor when it comes to financial planning for your ESPP can be beneficial because they will think about other items you may not have considered.
Enrolling in an ESPP is a great way to help you meet your financial goals, both short-term and long-term.
If you still aren’t sure about whether an employee stock purchase plan is right for you, check out our free and helpful guide here, or download it using the form below for instant delivery to your inbox.