There can be a lot of confusion, anxiety, and stress around finance questions that originate in the workplace. For example, if you have access to an Employee Stock Purchase Plan (ESPP) at work, you may be unsure if it’s a good investment. You also might wonder how it’s taxed and whether to enroll in it.
To clarify and demystify the process, we’ve prepared a guide to help you navigate the fundamentals of an ESPP.
What is an Employee Stock Purchase Plan (ESPP)?
An ESPP is an employer benefit offered at some publicly traded companies that lets employees purchase shares of their company’s stock at a discount, with funds deducted from their paycheck.
A typical ESPP program permits employees to enroll for a 12-month offering period. Participating employees choose to have a portion of their pay (up to 15%, or $25,000 per year) set aside by their company. Every six months, those funds are used to buy shares of the employer stock at a price below market value (typically a 15% discount).
In some cases, an employer will offer a “lookback period” as an additional benefit. The employee still receives a 15% discount; however, the discount is applied to whichever is lower — either the value of the stock on the first day or the final day of the period.
Typically, only full-time, permanent employees are eligible to participate in an ESPP program. With few exceptions, shares must be offered to all eligible employees of the company.
How is an ESPP Taxed?
Before you decide to max out your ESPP plan, it’s important to understand how an ESPP is generally taxed. ESPP shares are post-tax. In other words, your employer stock is purchased with money on which you’ve already paid taxes. Taxes are only due when the ESPP is sold.
If you purchase shares and immediately sell them, expect to pay income taxes on the 15% discount, which is considered compensation by your employer. If you hold ESPP shares after purchase and they appreciate in value, you may pay capital gains taxes in addition to income tax on the discount.
To qualify for favorable long-term capital gains taxes, your shares must be held more than two years after the start of the offering period, and more than one year after your purchase date. Although holding stock can result in favorable tax treatment, there are risks to consider.
Are ESPPs Good Investments?
These plans can be great investments if used correctly. Purchasing stock at a discount is certainly a valuable tool for accumulating wealth, but comes with investment risks you should consider. To help you understand the value of an ESPP, we’ve illustrated an example below.
Suppose you contributed the maximum amount of $25,000 to your ESPP over a 6-month period. At the beginning of your contribution period, the stock price is at $20 per share, but it’s at $22 per share at the end of the offering period. Because your ESPP has a lookback provision, the 15% discount is applied to the lesser stock value during the offering period. A 15% discount on $20 per share equates to a purchase price of $17 per share. This means your $25,000 contribution can purchase 1,470 shares of company stock.
If you immediately sell the ESPP shares, your sales proceeds will be $32,340, which is the current share price ($22) times the number of shares you own (1,470). Your profit on this transaction is $7,340 ($32,340 minus your cost to purchase the shares of $25,000).
On first inspection, it looks like your return on this investment is 29.4% ($7,340 profit divided by your cost of $25,000); however, because your $25,000 was contributed over a 6-month period, the first contribution was tied up for 6 months while the last contribution was tied up for only a few days. On average, your money is only tied up for 3 months. Earning 29.4% risk free for tying up your money for 3 months is equivalent to earning (1 + 29.4%) ^ 4 – 1 = 180% a year. This is why participating in ESPPs can be a boon for your financial situation.
ESPP Lifecycle Example
Should I Participate? If So, How Much?
It’s best to consider an ESPP contribution strategy in the context of your overall financial plan. Creating a personal financial strategy often involves weighing a variety of interrelated investment, tax, budget, and behavioral considerations, which can be overwhelming to those who don’t have professional help and the right tools. Although everyone is different, we do see some common patterns.
Highly compensated employees at firms offering ESPP programs are often also awarded employee stock options and restricted stock as part of their compensation. If their company has done well, they may actually own too much of their company stock (as a percentage of their portfolio). Additional purchases of employer stock would further concentrate their investments and create unnecessary risks if the stock fails to perform.
In this example, an employee may still want to take advantage of their 15% ESPP discount and have the income to save. In addition, these employees often have access to several types of tax-advantaged accounts. These include Traditional or Roth retirement savings, Healthcare Savings Accounts, or Deferred Compensation plans that offer better long-term tax advantages than their ESPP program.
If you find yourself with equity compensation outside of the ESPP, you can learn more about employee stock options and how to exercise them since they can be a significant component to your employer benefit package.
Make the Most of Your Employee Stock Purchase Plan
This is just an introduction to the many considerations involving ESPPs. They can sometimes be complex, but with the right mix of thoughtfulness and context, they are not unsolvable.
If you’d like to discuss your ESPP program and how it fits into your financial journey, we’d love to talk! Schedule a call with an Abacus advisor today.