Congratulations! Your employer has an Employee Stock Purchase Plan (ESPP)!
It’s easy to know what to make of excellent healthcare or an annual bonus, but it’s harder to wrap your head around how to participate in a well-managed ESPP. Should you participate? How much should you contribute? Is it time to stop contributing? How can I make the most of this? And what about the tax implications?
In this blog, we’ll dive into what being a part of an ESPP means and why you should consider taking advantage of this benefit.
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.
An ESPP is a valuable benefit offered by some publicly traded companies. It allows employees like you to buy company stock at a discount of up to 15% of the fair market value (discounts start as low as 5%).
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.
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:
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) |
What would your tax liability look like if you were to sell your stocks today? Use our ESPP Calculator tool to find out.
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.
Not sure how much to contribute or if you’re contributing enough? Start by tracking your net worth and then use this free cash flow worksheet to determine where you consistently spend money. This will help you wrap your arms around available cash flow to potentially point toward a discounted program. Check out this blog for more info. It’s a nuanced equation to decide where excess cash flow can work hardest for you, but employee stock purchase plans are generally very appealing. Tapping a professional can be very helpful.
If you find yourself cash-strapped because you over-contribute 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. In many situations, it’s better to try to right-size your contribution than set up complex back-end ways to make ends meet that could be put at risk of market volatility or an unplanned tax bill.
The good news is that 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. “nonqualifying” dispositions.
Qualified ESPP: Designed and operated according to IRS 423 regulations. They tend to have a better outcome with taxes.
Nonqualified ESPP: Does not operate according to IRS 432 regulations. This means there is more flexibility in designing nonqualified plans, but you lose some tax advantages.
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.
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.
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. Feel confident in your decision to participate in an ESPP either way.
ESPPs can help you more quickly fund your near-term goals, such as buying a second 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 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.
ESPPs can also help you reach longer-term goals, like 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.
Just be sure you are diversifying your portfolio because too many of one stock could hold financial implications. Learn more in this blog.
For example, if Alex consistently contributed $450 every paycheck for 10 years, that could add up to as much as $200,000, pre-tax, all in a single stock.1
An wealth manager can help you maximize your ESPP opportunities and tie everything back to your financial plan. Reach out today to see how Plancorp can help. [insert contact CTA]
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:
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 that a well-managed ESPP is indeed worth celebrating.