Congratulations, your employer has an Employee Stock Purchase Plan (ESPP)!
What’s that you say? You’re not sure congratulations are in order? That’s understandable. It’s easy to know what to make of excellent healthcare or an annual bonus. It’s harder to wrap your head around how to participate in a well-managed ESPP.
The Inner Workings of Your ESPP
Admit it. Before your employer offered you one, you might have guessed an ESPP was a sports channel, or an advanced type of extra sensory perception.
In reality, an ESPP is a valuable benefit offered by some publicly traded companies. It allows employees like you to purchase company shares at a discount, often at 5%–15% of the fair market value.
It doesn’t take a degree in mathematics to recognize that can be a good deal. However, as with most company benefits, there are rules and limits to each ESPP. Here’s what to look for as general “operating instructions.”
First, there’s the enrollment period, which typically comes along twice per year. Once you enroll, you decide how much you’ll contribute. Your company will open your personal ESPP account, and automatically fund it directly from your paycheck. After a purchase period (often six months), you reach a purchase date, when the account balance is used to purchase company shares.
Let’s look at an example.
Alex enrolls in her company ESPP during the November enrollment period. The company starts taking payroll deductions on a December 1 offering date. It purchases shares for Alex on June 15, using the accumulated cash from December 1 – May 31. Alex’s company automatically re-enrolls her for the next cycle, taking payroll deductions for the June 1 – November 30 purchase period.
The lookback provision
An ESPP is an especially enticing benefit if it includes a lookback provision. With this, the ESPP can “look back” when buying your shares, and discount your purchase price to the lower of either the offering date or the purchase date share price. This can boost your benefit in two ways:
- If the share price moves up during the purchase period, it magnifies the gains.
- If the share price moves down during the purchase period, your optimal discount remains guaranteed.
Let’s continue with Alex’s example. Just after she enrolled in her company’s ESPP on November 30, we’ll assume the stock’s fair market value was $100/share on the December 1 offering date, and her employee discount is 10%.
Up scenario: The stock does well over the purchase period and is trading at $110/share on the June 15 purchase date. The ESPP will purchase shares for $90 (a 10% discount from the offering date price). Although Alex’s ESPP discount is 10%, her upfront return is 22% ($90 à $110).
Down scenario: The stock hits a rough patch over the purchase period and is trading at $80 on the June 15 purchase date. The ESPP will purchase shares for $72 (a 10% from the purchase date price). Although Alex’s company shares dropped 20%, she still makes out with an immediate 11% return ($72 à $80).
Better yet, these scenarios are over just six months, so returns would be even greater on an annualized basis. If the share price goes up during the purchase period, you win big. If the stock price drops, you still win. Some companies offer lookback periods that run as long as 24 months, with six-month purchase periods in between. If your company shares do well over that time, you could experience incredible financial benefits.
Given what a good deal an ESPP can be, it’s not surprising there are limits to how much you can contribute. The IRS currently sets a pre-discount upper limit of $25,000 per calendar year. So, for ESPPs with a 10% discount, the most you can purchase each calendar year is $22,500.
|$25,000 worth of stock
–$2,500 (10% discount)
$22,500 (max contribution)
Companies often further restrict contributions. The cap varies, but often ranges from 10%– 20% of your salary. Your company can also place a dollar limit on the contribution below the IRS limit.
Also, take note: The percentage of income you elect to contribute is based on your pre-tax salary, not your take-home pay. That means a 10% election will decrease your take-home paycheck by more than 10% after all tax withholdings and various deductions.
Alex’s salary is $108,000 and she elects to contribute 10% to her ESPP. She receives 24 biweekly paychecks for $4,500 before any withholdings, so her ESPP contribution will be $450 per paycheck. After federal tax withholding, 401(k) contributions, commuter benefits, and other deductions, Alex’s take-home pay maybe closer to $3,000, so a $450 deduction is a 15% decrease in take-home pay.
If you find yourself cash-strapped if you overcontribute to an ESPP, you can sell some shares as soon as they are purchased to generate extra income. However, it is important to understand the tax ramifications of selling ESPP shares. In fact, ESPP tax planning deserves a conversation of its own.
The good news is, you only incur taxes when you sell ESPP shares, not when you purchase them. The less-good news is that ESPP tax planning is complicated by “qualifying” vs. “disqualifying” dispositions. Let’s work through an example for each.
Alex’s company shares traded at $100 at the offering date and $110 on the purchase date. With the $5,400 accumulated over six months, the ESPP purchases 60 shares at the discounted price of $90 and deposits them in Alex’s account.
Example 1: A disqualifying position (selling right away)
Selling ESPP shares right away is a disqualifying disposition. In a disqualifying disposition, any gains in the shares are taxed at (typically higher) ordinary income tax rates.
Alex sells all 60 shares right away at $110/share. Her $5,400 investment has turned into $6,600 for a gain of $1,200. The entire gain is taxed at ordinary federal income tax rates, as well as any applicable state and local income tax. Payroll tax for Social Security and Medicare is not required on any income generated from ESPP.
Example 2: A qualifying position (selling after a waiting period)
ESPP shares are eligible for preferential tax treatment under a “qualifying disposition.” To make a qualifying disposition, shares must be held for at least two years after the offering date, and at least one year after the purchase date.
Alex’s offering date started on December 1, six months before the purchase date, So Alex needs to hold her shares for 1.5 years to have held them for two years after the offering date. By waiting 1.5 years, she would naturally also satisfy the requirement to hold them for at least one year after the purchase date.
A qualifying disposition allows gains above the discount to be taxed at (typically lower) long-term capital gains rates. The company discount is always taxed as ordinary income.
Alex sells all shares after 1.5 years at, say, $110/share. As a qualifying disposition, the $1,200 gain is taxed partially as income and partially as capital gains. The discount of $10/share ($100 à $90) is taxed as ordinary income, and the rest of the gain ($100 à $110) is taxed at the long-term capital gains rate.
The question then becomes: Should you sell right away to diversify your portfolio, or wait to minimize taxes? That depends in part on your tax situation, and how much the shares have appreciated over the purchase period. Assuming Alex is in a 24% marginal income tax bracket and 15% for long-term capital gains, she would save roughly $50 by waiting to sell.
If the gains are significant, waiting to sell could have a bigger impact. For example, if Alex made a qualifying disposition at $200 instead of $110 per share, she would save $540 by waiting. Her savings would be even greater if she were in a higher tax bracket.
That said, if you continue to hold the shares, even a small fall in price can more than offset the tax savings. A 1% drop would wipe out a $50 tax savings, and a 5% drop would wipe out a $540 tax savings. So, if you value locking in your gains and using them to diversify the proceeds across your greater portfolio, you may still prefer to take an immediate, disqualifying disposition, even if you’ll pay higher taxes.
Using ESPP Proceeds to Fund Your Financial Goals
When you stick with your Employee Stock Purchase Plan, you’ll have a big chunk of stock coming your way every six months or so, presenting several opportunities to advance your financial goals. Here are a few possibilities.
1. Supplement your cash flow
When you first enroll in an ESPP, it may hurt to see that chunk of change coming out of your paycheck. But properly managed, you can ultimately end up with more after-tax “pay” compared to not participating.
How so? As long as you can make it through the first purchase cycle, you can expect to sell your ESPP shares as soon as they vest for more than you paid for them. Even in a disqualifying disposition, you should come out ahead.
2. Save for near-term goals
ESPPs can help you more quickly fund your near-term goals, such as buying a home in the next year or two. Even after-tax, your rate of return from selling vested ESPP shares as soon as you receive them should be many times higher than today’s highest-yielding savings accounts. It’s like adding a power ball to your savings every time a new batch of stocks vest in your account.
3. Invest toward long-term goals
ESPPs can also help you reach longer-term goals, such as retirement. Whether you hold company shares as a small part of your overall portfolio, or diversify them periodically, the compounding of ESPP can add up quickly. For example, if Alex consistently contributed $450 every paycheck for 10 years, that could add up to as much as $200,000, pre-tax.1
Planning To Benefit From Your Company ESPP
Before we wrap, let’s unpack our statement about holding company stock as a small part of your portfolio.
Before you decide to hang onto ESSP shares indefinitely, it’s critical to understand how to manage the very real risks involved. Like any other individual stock, your company’s stock is a highly concentrated investment risk – especially since it’s tied directly to your career. (That is, if the stock price plummets, your career may well tank at the same time. Ouch.)
To avoid going overboard, we suggest establishing the following priorities:
- Make an investment plan: First, define the role you would like your company stock to play in your total investments by building it into a total investment plan. (Hint: This would be an excellent time to engage a financial advisor to help with that.)
- Stick to your investment plan: Even if you choose to hold fast-growing ESSP shares, you’ll probably want to periodically sell some of them, and reinvest the proceeds into low-cost index funds or similar vehicles. This takes some of your concentrated risk off the table, while ensuring your investments remain well-diversified according to plan.
ESPPs can be a great way to build wealth and more quickly achieve your personal financial goals. Maximize this great benefit by beginning with a solid plan to lead the way. Build it based on your particular circumstances, manage it for the world’s greater risks, and revisit it periodically to ensure you remain on track.
With that, we hope you’ll now see: A well-managed ESPP is indeed worth celebrating.
Disclaimer: This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors.
1 Figure assumes an 8% annual return. The exact balance would be $196,535.