A Guide to Your Employee Stock Purchase Plan
Employee stock purchase plans (ESPP) give plan participants the ability to purchase shares in their company stock at discounted rates. ESPPs, sometimes called Associate Stock Purchase Plans or other branded names, are overlooked but are a smart way to invest. You could be leaving thousands of dollars in free money on the table by not taking advantage of your company’s plan.
These plans are more widely available now. Almost 50% of S&P 500 companies offer ESPP and 38.5% of firms listed in the Russell 3000 have plans. If your company does offer an ESPP, there is a pretty good chance you are not participating since less than a third (31%) contribute to their plan.
What do you need to know?
You will sign up to participate during the enrollment period. At this time, you’ll select what percentage of your paycheck or specific dollar amount you would like to contribute to the plan. Employers will deduct your contribution amount from your paycheck each pay period and place it into a trust account. The beginning of this called the called It will accumulate for a period of three to six months. At the end of the three or six-month period (the purchase period), shares will be bought for you based on the specifics of your plan. The discount ranges from 5% to 15%.
The purchase price is the price of your stock at the market close (minus your discount) on the purchase date unless your company has a lookback provision. Lookback provisions allow you to purchase shares at the lower price (minus the discount) of either the price at the start of your offering period or on the purchase date. This gives you the best opportunity for profits! If the stock is at $100 at the start of your period and ends at $110, you will buy your shares at $85 ($100 minus the 15% discount). If your company’s plan offers a stacked benefit, it makes participating more attractive.
The maximum contribution you can make to an ESPP is $25,000. This amount is an IRS rule, not something specific to your company plan. Some plans also limit your contribution to 10% of your take-home pay.
Things to keep in mind
Participating in an ESPP is an overlooked way to build your net worth. By having the routine of money deducted out of your paycheck, then purchasing shares at a discount, and the possible appreciation of your company’s stock price, you can compound this account over time. One common issue we see is employees don’t sell shares in their ESPP. As high as 59% of employees never sell while they are at their employer. This can lead to holding a concentrated position in your company stock and the urgent need to diversify. People tend to hold on to their shares out of loyalty, being part of the team, or just don’t know what to do. Work with your financial planner or tax professional if you need help or have questions.
When to sell?
The brokerage firm that holds your shares and administers the plan will let you know if there is a holding period or restricted period for your shares. Depending on your position with your company, you may only be able to transact during specific windows during the year. Taxes do play an important part in any decision to sell.
We will focus on Qualified ESPPs since the vast majority fall under this type. The tax treatment when you sell is based on how long you have held your shares and your tax bracket. Your holding period will determine if you have a qualifying disposition or a disqualifying disposition.
A qualifying disposition of ESPP shares meets either of the following criteria:
The shares must be held for at least one year past the original purchase date.
The shares must be held for at least two years after the original offer date.
If your stock is not in either of these categories, then it is a disqualifying disposition of ESPP shares.
The discount you receive on your shares is taxed at your ordinary-income tax rate; let’s assume 32%. If you sell your shares immediately, your profits would be taxed only at your ordinary-income rate. If you hold onto your shares for longer than a year after purchasing them, you get more favorable tax treatment. You will still pay ordinary income tax on the discount received but your other profits will be taxed at long-term capital gains rate. Remember, you only pay tax when you sell.
Let’s look at an example. In the first table, we look at a disqualifying disposition. We used three scenarios of a positive market, a flat market, and a down market. The after tax gains are on the bottom row and all gains are taxed at your ordinary income tax rate because you would be making a disqualifying disposition.
In the second chart, the information is for a qualifying disposition because you held longer than a year. The after tax gains are the same in both flat and down market scenarios. Where the difference is meaningful is when you see gains in your ESPP. You get to keep more of your gains, on an after tax basis, if you plan to hold your shares for more than a year.
ESPPs are another tool for you to grow your net worth. They do require a little more attention than your 401k because you are the one who is going to decide to sell. As your balance increases, it will become more critical to understand how your ESPP fits into your overall financial plan. If you don’t take action, it could lead to having a concentrated position in your employer’s stock and you may be taking more risk than you should be.
Learn more about ESPPs by clicking on the video below and be sure to subscribe to our YouTube channel so you can be the first to know when we add new educational materials like this.
Andrew Comstock, CFA
Principal Wealth Advisor