Employee Stock Purchase Plans: Should You Use Them?

Employee stock purchase plans, or ESPPs, allow companies to give their employees a stake in the company. The plan lets employees buy shares of stock at a discount.  The problem is that it may not be clear what an ESPP is or when to use it.

ESPPs are one of the best ways for employees to build wealth over time through stock investment. But it isn’t right for everyone. Should you use it? Let's dive in to find out. 

What is an employee stock purchase plan (ESPP)?

ESPPs, otherwise known as employee stock purchase plans, are a way for employees to buy shares of their employer’s stock. It's a voluntary program that gives employees of a company an opportunity to purchase shares at a discounted stock price. 

The plans are often combined with other programs, such as 401(k) programs, to provide additional options to invest in your future and in the future of the company you work for.

However, many nuances exist in a program like this — from tax strategies to the possibility of losing your investment — so it's worth learning all you can before you decide whether it is right for you. 

How an ESPP works

When you join an ESPP, you become a participant in that plan. Employers typically allow you to contribute through payroll deductions that build up between the offering date and the purchase date.

The offering date is the date your company starts to deduct ESPP contributions from your paycheck. The company issues stock to participants at a price below market value. For example, if shares are trading at $10 per share, an employee participating in an ESPP might purchase stock at a discounted price of $8.5 for each share. 

Some employers have ESPPs available to employees only during specific periods of time. Other employers choose to make ESPPs available year-round with different purchase periods so all employees can participate at their discretion. 

 

What are the tax consequences of an ESPP?

Before you max out your ESPP plan, you must understand how contributions and earnings are generally taxed:

  • ESPP shares are purchased with after-tax dollars

  • You pay taxes only when the ESPP is sold

Contributions you make to your ESPP are made with money that you’ve already paid taxes on, so you don’t get a tax break for enrolling and purchasing shares.

But if the stock appreciates in value, you’ll pay taxes on capital gains — but only when you sell your shares. A capital gain is when you sell a capital asset for more than you paid for it. Generally, long-term capital gains from selling shares in an ESPP are taxed at lower rates. 

If you have a short-term capital gain from selling your shares in an ESPP, you’ll pay ordinary income tax rates. Plus, if you purchase shares and sell immediately, you may also pay income taxes on the discount you got when buying them — that’s because the ESPP discount is considered compensation by your employer.

What happens if you change jobs?

When you leave your job or if your employment ends, you’ll have a range of possible outcomes to consider. Ultimately, it depends on:

  • If your shares are vested and exercised

  • If your employer is public or private

  • Why you’re leaving the company (retirement, new job, termination with or without cause)

  • Additional specific terms you may have negotiated with the company

Before you part ways with your employer, download and save all your stock plan documents. You can also benefit from speaking with a financial advisor and possibly an attorney about your options — it can help your money mindset to fully understand the implications you’re facing.

Are ESPP good investments?

ESPPs have been around for a long time and, because they generally require a relatively small investment, can be a good deal for employees. However, they aren’t ideal in every situation. 

Depending on what tax bracket you fall into now and how much money you need in retirement, an ESPP might cost you more money by exposing your stock sales to more taxes. 

However, ESPPs have many benefits that can help fund your financial goals. By enrolling, you could receive a large amount of stock every six months or so. You could use the opportunity to:

  • Supplement your cash flow

  • Save for near-term goals

  • Invest toward long-term goals

You’ll get the most out of your investment if you make a plan. Deciding how to leverage your company stock as part of your investment portfolio is key.

Can you lose money on an ESPP?

This is one of those things that surprises people — it’s possible to lose money on an ESPP. You’re buying shares of stock, and the value of ESPP shares can go up or down very quickly. 

A 15% drop in price can eliminate the value from participating in the plan in the first place. You don’t want to invest a large portion of your nest egg into an ESPP. It ties your future financial success to the performance of one firm, creating undue risk.

Participating in an ESPP can be beneficial, but only if you understand the risk involved and use the options as part of a diversified portfolio.

When you should participate in your ESPP plan

If you can afford to set aside a portion of your paycheck, is an ESPP worth it? It depends. Typically, the bigger the discount your company offers, the better deal the ESPP is. 

It also depends on your tax rate now, how long you plan to hold the shares, and what you think your tax rate will be when you decide to sell them. For example, depending on your income level, you may not have to pay any long-term capital gains tax if you hold onto your shares for longer than a year. 

If you’re not sure and would rather participate in a lower-risk investment, consider your employer’s 401(k) plan. If your employer offers a 401(k) match, you get one of the best benefits an employer can offer — it’s essentially a 100% risk-free return.

ESPPs have several key features that may make them attractive, but they have significant downsides, too. Ultimately, you must consider all your available options before making a decision on whether or not ESPPs are right for you. 

A financial advisor can help you sort through the considerations and point out any pros and cons of using ESPPs. Then, you’ll have an objective opinion in light of your unique circumstances and preferences and can choose a plan that works best for you.

Andrew Comstock, CFA

Principal - Wealth Advisor

Andrew Comstock, CFA