This is the third post in a series on employer stock programs. Check out the previous posts on Incentive Stock Options and Non-Qualified Stock Options.
Employee Stock Purchase Plans (ESPPs) can be a great way to take advantage of buying shares in your company stock at a discounted price, typically 10-15% off. Plus, your company makes it extremely easy to participate because you purchase shares directly through payroll deductions.
You can decide during the offering period (which is generally twice a year) what percentage of your paycheck to contribute to the plan (up to $25,000 per year). Contributions to the ESPP are made with after-tax income. I recently discussed ESPPs on CNBC — check it out!
How Does Contributing to an Employer Stock Purchase Plan Work?
If you participate in an ESPP, you’d contribute through payroll deductions for a defined period of time (usually 3-6 months). This time period begins with the offering date and ends with the purchase date.
On the purchase date, the company uses the accumulated funds to buy shares in the company on behalf of all the participating employees, and the respective number of shares that each employee purchased is deposited into their ESPP account.
Some plans include a lookback provision, which is when you can purchase the stock at the price it was at the beginning or end of the offering period, whichever is lower. You would also get the discount on top of this lower price.
What Does This Look Like IRL?
For example, let’s say you want to contribute $10,000 through your ESPP. The share price at the beginning of the offering period (six months ago) was $40, but the current share price is $50.
Your ESPP lookback provision allows you to lock in the $40 price plus a discount, so you’ll actually receive 250 shares instead of 200 shares at the current price. Using the same example, if you got a 10% discount, you’d receive 277 shares at $36 a share.
Keep in mind that there is usually a limit to how much you can invest in an employee stock purchase plan, such as no more than $25,000 per year or 15% of your salary.
What Happens When You Sell Shares?
If you hold your ESPP shares for more than one year after the purchase date and more than two years after the beginning of the offering period, then it will be considered a qualified disposition. As a result, any profit above the gain from the discount will be taxed at the lower long-term capital gains tax rates (15% for most taxpayers). The holding period for long-term capital gains is extended if the offering period resets.
How to make this easier: try logging in to your ESPP online. Most of the time you’ll be able to see whether the lot of shares you purchased qualifies for long term or short term gains. You can pick and choose which lots you’d like to sell.
If you sell your ESPP shares within two years of the offering date or within one year after the purchase date, it will be considered a disqualifying disposition. As a result, any profit above the gain from the discount will be taxed at your higher ordinary income tax rate.
Unlike retirement plans, where you’re penalized for withdrawing before retirement age, you are free to sell shares at any age to fund any financial goal.
What Are the Rewards and Risks of Participating in an ESPP?
Rewards
Obviously, the opportunity to purchase shares of your company at a discount is a big incentive! Additionally, you’ll have the convenience of buying through payroll deductions, and many companies will even match your contributions.
When you purchase stock through an ESPP, the income is not taxable at the time you buy it. You do not recognize any income, nor do you pay any tax, until you actually sell the stock.
Risks
Investing a large percentage of your portfolio in one company always comes with risks. You may want to participate to get the discount, hold shares long enough to pay long-term capital gains on the sale, and then reinvest elsewhere for greater diversification.
On the other hand, sometimes it makes sense to sell and pay higher taxes, as it allows you to lock in your gain and then reinvest in a more diversified portfolio elsewhere.
It’s easy to have an emotional bias when it comes to company stock. You feel very comfortable investing in company stock because you know the company, you know the people, and you know the product and service.
How Does This Tie Into Your Other Financial Goals?
We generally recommend maxing out your 401(k) before taking advantage of your ESPP due to the tax advantages of 401(k)s and diversification of the portfolios. You should at least be contributing enough to take advantage of your full company match. Make sure you’re on track for retirement before investing in any particular individual stock.
That being said, ESPPs can be an extremely useful tool in helping you reach other financial goals, especially if you get a 10-15% discount. For some of our clients, they may max out their ESPP contributions and turn around and sell ASAP to try to lock in the gain. Even though they’ll pay short term capital gains, they can use this money to fund other financial goals such as paying down student loans, saving for a down payment on a home, or diversifying this money in a brokerage account.
Ask for Help
Keep in mind that every company is susceptible to a weak economy, and you never want to hold onto an investment based solely on tax implications or on how it performed in the past. It can be extremely helpful to reach out to a CPA to have a tax projection run when you’re considering selling your company stock.
In addition, this is why it is a good idea to reach out to an objective financial planner review your company stock plan and assist you with a plan to divest from a concentrated company stock position in the most effective manner possible. Ultimately, we want to help you use your money to match your values to live an amazing life!
