Would you buy a fine, fresh $100 bill for $85, if I offered it to you?
Isn’t it self-evident?
Employee Stock Purchase Plans (ESPPs) are a popular employee compensation programme that allows you to do just that—buy company stock at a discount.
We’ll go over how these programmes work, where you have an edge (and where you don’t), and how to use them to your advantage so you can always receive that $100 bill at a discount.
We’ll go through the five things you need to know in order to get the most out of your Employee Stock Purchase Plan:
What exactly is an ESPP?
What is an ESPP and how does it work?
When should you take part in your ESPP plan?
How are ESPP shares taxed?
Also, how to use ESPP shares to help you reach your financial objectives faster.
Let’s get this party started.
What exactly is an ESPP (Employee Stock Purchase Plan)?
An ESPP is an employee perk offered by most publicly traded firms that allows you to acquire shares of your company’s stock at a discounted price. The most significant benefit of Employee Stock Purchase Plans is the discount.
You should expect a discount of between 5% and 15% from most employers—obviously, the larger the discount, the better! These shares can then be sold right away (known as a “Quick Sale”), resulting in a tidy profit with no risk.
It’s because of this discount that you can use an ESPP to boost your savings.
Now, there are some specific rules about how much and when you can contribute, how the shares are taxed when you sell them, and other details that we’ll go over later, but for now, remember that an ESPP allows you to buy shares of your company stock at a discount and then sell them right away for a profit.
So, if you just remember one item from this article, it should be this:
“ In most circumstances, if your workplace offers an Employee Stock Purchase Plan and you haven’t enrolled yet, you should stop what you’re doing and go enrol! “
What is an Employee Stock Purchase Plan (ESPP) and how does it work?
Employees can choose to defer salaries and bonuses up to the IRS limit of $25,000 per year (the “Contribution Limit”) under an ESPP scheme. During an initial “Enrollment Cycle,” you choose how much to donate per pay period.
This money is used to acquire shares at a discount of up to 15% at the end of the enrolment period, which is usually every six months. This discount is sometimes applied via a “Lookback Period,” in which shares are purchased at the lower of the price at the beginning of the enrollment period (the Offering or Grant Date) or the conclusion of the period (the Exercise or Purchase Date).
The timeline displayed below is an example of an ESPP timeline.
Let’s take a closer look at the main terms discussed earlier.
Period of Enrollment
Typically, your ESPP will have an enrollment period every six months. You’ll choose whether or not to participate in the plan and how much to put into it each pay period. Each pay period, your contributions to the plan will be deducted straight from your paycheck and deposited into your ESPP account.
The money will be used to purchase shares of your company stock at a discount to their market value at the conclusion of the period, on the purchase date.
There are two ways that the discount might be applied to plans with a “Lookback Period.”
Your shares are purchased at a discount to market value on the Purchase Date (at the end of the Enrollment Period) or, if your plan includes the appealing “lookback” function, at the price (if it’s lower) from the beginning of the period (if it’s lower) (the Grant Date).
This “lookback” function is appealing because it allows you to buy shares at the lower of two prices: the price at the start of the term or the price at the conclusion of the period. Consider the following scenario.
Example 1: Increasing Share Price – Your employer’s stock begins the offering period at $10 per share and rises to $15 per share by the purchase date. You can buy shares at a discount to the lower of these two values, $10/share, thanks to the lookback provision.
Example 2: Falling Share Price — At the start of the offering period, your employer’s stock is trading at $20 per share, but by the buy date, it has dropped to $15 per share. The lookback provision isn’t in effect here, so you can acquire shares at a discount to the current price of $15 per share.
The lookback provision is a terrific benefit since it either magnifies your gain in a rising share price scenario or allows you to buy shares at a discount to the current market value (and sell quickly to lock in this gain, known as a “Quick Sale”) in a falling share price scenario.
Limitations on Contribution
The IRS sets a limit of $25,000 in pre-discounted contributions to your Employee Stock Purchase Plan (ESPP) per calendar year.
Here’s how your contribution cap looks with different discounts:
Companies can limit your contributions to a percentage of your pay or a fixed monetary amount if they want. The normal maximum salary contribution to an ESPP is between 10% and 20% of one’s pay.
It’s crucial to remember that your ESPP contributions are calculated based on your gross pay (before taxes or withholdings are deducted).
Consider the following scenario: You choose to contribute 10% of your salary to your ESPP, and your annual salary is $200,000, and you are paid monthly. Your ESPP contributions total $20,000 per year, or $1,666 each month. Assume that your monthly take-home pay is $10,000 after withholdings and deductions for taxes, 401(k) contributions, health insurance, and other expenses.
As a result, this $1,666 monthly payment (10% of gross earnings) represents a higher percentage (16.6%) of your net take-home pay.
Should You Take Part in Your Company’s Employee Stock Purchase Plan (ESPP)?
Is it wise to invest in an ESPP?
So, as we stated at the start of this essay, would you buy a $100 bill for $85, if I offered it to you?
It’s a no-brainer if you have $85 on hand, right?
It’s no different if you’re a part of your company’s Employee Stock Purchase Plan. If you can afford it on a monthly cash flow basis, you should take advantage of the opportunity.
As previously stated, the discount is the major benefit to take advantage of in an ESPP. Shares can be sold quickly (known as a “Quick Sale”), resulting in a minimum 18 percent pre-tax gain assuming a 15% discount.
We always get at least 15% off the market price at the Purchase Date with a lookback period, and sometimes more if the stock price has increased since the commencement of the offering period. The payment profile can be shown in the chart below, assuming a $10 price at the start of the offering period and a 15% discount.
You have a guaranteed minimum gain with upside potential due to the discount.
Isn’t it a good investment?
Employee Stock Purchase Plan (ESPP) Taxes: What They Are and How They Work
An ESPP is a relatively simple programme that only becomes complicated when taxation is included in.
Taxes aren’t owed until you sell your shares in an ESPP, but the tax treatment differs depending on whether the sale is a “Qualifying” or “Disqualifying” disposition.
The following are the two sorts of dispositions:
- Qualifying shares are those held for two years from the date of grant and one year from the date of purchase.
- Disqualifying: Does not match the above-mentioned requirements. Shares must be held for two years from the date of grant and one year from the date of purchase.
A portion of the discounted purchase price is recognised as income when shares are sold under a Qualifying disposal, but the remaining gain (if any) is taxed at lower long-term capital gains rates.
That may sound appealing, but it has a significant disadvantage.
You must keep the shares for at least another year after the purchase date, and you risk losing money if the price falls.
Unless you’re seeking to actively accumulate shares of your company’s stock, the tax advantages of ESPP shares aren’t something you should take advantage of.
We normally advocate selling the shares as quickly as possible via a “Quick Sale” to lock in the free money from the discount (which could be lost if the stock price decreases while waiting for the disposition to become Qualified).
As a result, ESPP shares are taxed as follows:
- If you qualify, you will be taxed on the discounted purchase price as regular income. Any profit over this threshold is taxed at the lower capital gains rate.
- If you are disqualified, the difference between the market value of your shares when you sell them and your (discounted) purchase price is taxed at 100% as ordinary income and is subject to federal, state, and local taxes.
Consider the following circumstance, which has both qualifying and disqualifying dispositions:
Scenario: Morgan’s company provides a six-month ESPP with a one-year lookback term and a 15% discount every six months. The price per share is $40 at the start of the period and rises to $50 on the purchase date. Morgan’s donation is used to buy 250 shares of her employer’s stock at a discounted price of $34 per share ($40 x 15% discount = $34 per share).
Morgan must retain her 250 shares for another 1.5 years to qualify for the favourable tax treatment.
- Example #1 – Qualifying Disposition (Share Price Remains Level): Morgan must hold her 250 shares for another 1.5 years to qualify for the favourable tax treatment. If the price of her shares does not fall during that period and she sells them for $50 each, the $1,500 discount ($40-$34 = $6 discount/share) is taxed as ordinary income, but the remaining $2,500 gain ($50-$40 = $10 gain/share) is taxed as capital gain.
- Example #2 – Qualifying Disposal (Share Price Drop): As previously stated, Morgan will miss out on the discount if the stock price declines while she waits for the disposition to become qualified. When Morgan’s shares are sold at the end of the 1.5-year period, the price has fallen to $30 a share. Morgan’s $1,500 discount ($40-$34 = $6 discount per share) is cancelled out by her $2,500 capital loss ($40-$30 = $10 loss per share). The position as a whole loses $1,000 in capital.
- Example #3: Assume Morgan sells her 250 shares for $50 per share immediately after the purchase date (a “Quick Sale”). The full gain of $4,000 ($50-$34 = $16 gain/share) is taxed as ordinary income because there is no advantageous tax treatment.
As you can see, if your stock rises dramatically between the start of the offer period and the exercise date, a large portion of the gain will be taxed at capital gains rates; nevertheless, you will be vulnerable to market fluctuations on the stock for another year. (Here’s a link to a useful ESPP tax calculator.)
Unless you have a specific financial goal in mind, we recommend selling your employer’s stock immediately and using the proceeds to either support an urgent financial goal or reinvest as part of your diversified portfolio.
On that point, we’ll look at how you may use ESPP shares to help you reach your financial goals faster and as part of a larger financial strategy.
Developing an ESPP Strategy to Achieve Your Objectives
Because of the lower purchase price, ESPP shares can be used as a turbo-charged savings account to help you achieve your financial goals faster.
Let’s have a look at a few options.
- Supplement your Cash Flow – While initially a drain on monthly cash flow, the programme can actually improve your annual cash flow after your initial enrollment period because shares are purchased at a 5 percent -15 percent discount. Consider this scenario: you contribute $10k to an ESPP every six months, and you utilise that money to buy (and then sell) approximately $11,760 of stock at a 15% discount (assumes no price appreciation; gains would be greater if the share price increases). Even after income taxes (assuming a total tax rate of 35 percent), you have a $1,055 boost in cash flow every six months.
- Short-Term Goals – Continuing with the previous example, you can use your Employee Stock Purchase Plan to accelerate your savings for short-term goals. $10,000 saved will get you $11,055 closer to your goal. When I worked in corporate finance a long time ago (before kids and grey hair), I utilised my ESPP to help fund the down payment on our first home.
- Boost Additional Savings in a Retirement Account (Traditional IRA, Roth IRA), HSA Account, or Simply Increase Your Savings in a Taxable Account — Even if you aren’t saving for immediate goals, your ESPP gains can be used to boost additional savings in a retirement account (Traditional IRA, Roth IRA), HSA account, or simply increase your savings in a taxable account.
- Transfer ESPP Shares to a Brokerage Account – Finally, if you want to collect shares of your employer’s stock at a discount, the ESPP programme can help. If you are particularly positive about your employer’s future (and risk-taking), or if you are working toward a minimum holding requirement in your company stock, you may wish to do so (required at many companies for senior executives and directors). After you’ve purchased the shares through the ESPP, you can transfer them to whatever brokerage account you like.
Finally, consider how an ESPP strategy might be integrated into the rest of your financial plan and investment strategy.
“When should I sell my ESPP shares?” is a common question. To that, we’d say it depends on the following factors:
- Determine how much of your company stock you want to keep – As we’ve already mentioned, keeping corporate stock is a risky option (read more about the risks of owning individual stocks and our 3 step plan for your company stock). You’re not only taking on the risk of investing in individual stocks; your pay, bonus, and other equity incentives, such as RSUs, are already linked to your employer’s success. The first step is to figure out how much employer stock you can hold. To begin, a percentage of no more than 10% is a suitable starting point.
- Automate Your Plan – Once you’ve decided how much company stock to hold, automating it is the simplest method to stick to it. Whether you decide to invest 0% or 10% of your liquid net worth in your employer’s stock, we recommend that whenever you hit that level, you configure your ESPP sale strategy to sell promptly so you don’t forget to sell the shares later and mistakenly exceed the limit you established.
As you may have gathered by now, if your workplace offers an ESPP, you should take use of it. With a little understanding of how the programme works and some thought into how to include ESPP shares into your overall financial strategy, they may be a strong instrument to help you get ahead financially.
We work with Technology professionals at Cordant to help them get the most out of their benefits, including ESPPs, RSUs, Deferred Compensation, and the Mega Roth 401(k), as well as provide holistic financial planning and investment management.