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.
What is an 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.
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.”
How Does an ESPP Work?
ESPP Enrollment
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 period. 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.
ESPP 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.
ESPP Contribution Limits
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.
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 may be closer to $3,000, so a $450 deduction is a 15% decrease in take-home pay.
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.
Tricky ESPP Taxes
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.
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 nonqualifying position (selling right away)
Selling ESPP shares right away is a nonqualifying disposition. In a nonqualifying 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 Employee Stock Purchase Plan Benefits 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. Feel confident in your decision to participate in an ESPP either way.
2. Save for near-term goals
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.
3. Invest toward long-term goals
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]
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 that a well-managed ESPP is indeed worth celebrating.
