Essential Guide to Your Employee Stock Purchase Plan (ESPP)

What is Employee Stock Purchase Plan (ESPP)?

Employee Stock Purchase Plan (ESPP) is a popular tool for companies to allow their employees to participate in the company’s growth and success by becoming shareholders. ESPP gives you the option to buy shares of your employer at a discount price. Most companies set a discount between 10% and 15%. Unlike RSUs and restricted stocks, the shares you purchase through an ESPP are not subject to any vesting schedule restrictions. That means you own the shares immediately after purchase. There are two types of ESPP – qualified and non-qualified. Qualified ESPP generally meets the requirements under Section 423 of the Internal Revenue Code and receive a more favorable tax treatment. Since most ESPP are qualified, I will only talk about them in this article.

How ESPP works?

Your company will typically provide you with information about enrollment and offering dates, contribution limits, discounts, and purchasing schedules. There will be specific periods throughout the year when employees can enroll in the plan. During that time, you are required to decide if you want to participate and set a percentage of your salary to be deducted every month to contribute to the stock purchase plan. The IRS allows up to $25,000 limit for Employee Stock Purchase Plan contributions. Make sure you set your percentage, so you don’t cross over this limit.

At this point, you are all set. Your employer will withhold your selected percentage every paycheck. The contributions will accumulate over time and will be used to buy the company stock on the purchase date.

Offering period

Offering periods of most ESPPs range from 6 to 24 months. The longer periods could have multiple six-month purchase periods. Your employer will use your salary contributions that accumulate with time to buy shares from the company stock on your behalf.

ESPP look-back provision

Some Employee Stock Purchase Plans offer a look-back provision that will allow you to purchase the shares at a discount from the lowest of the beginning and ending price of the offering period.

Employee Stock Purchase Plan  Example

Let’s assume that on January 2nd, your company stock traded at $100 per share. The stock price had a nice run and ended the six month period on June 30 at 120. Your ESPP will allow you to buy the stock at 15% of the lowest price, which is $00. You will end up paying $85 for a stock worth $120.

The price discount is what makes the ESPP attractive to employees of high growth companies. By acquiring your company stock at a discount, the ESPP lowers your investment risk, provides you a buffer from future price declines, and sets a more significant upside if the price goes up further.

When to sell ESPP stock?

Some ESPPs allow you to sell your shares immediately after the purchase date, realizing an instant gain of 17.65%. Other plans may impose a holding period restriction during which you cannot sell your shares. Find out more from your HR.

ESPP Tax Rules

Employee Stock Purchase plans have their own unique set of tax rules. All contributions are pretax and subject to federal, state, and local taxes.

Purchasing and keeping ESPP stock will not create a tax event. In other words, you don’t owe any taxes to IRS if you never sell your shares. However, the moment you decide to sell is when things get more complicated.

The discount is as ordinary income

The first thing to remember is that your ESPP price discount is always treated as ordinary income. You will include the value of the discount to your regular annual income and pay taxes according to your tax bracket.

Qualifying disposition

To get a preferential tax treatment on your stock gains, you need to make a qualifying disposition. The rule requires that you sell your shares two years from the offer date and one year from the purchase date. Your gains will be taxed as long-term capital gains. The long-term capital gain tax rate varies between 0%, 15%, and 20% depending on your income. 

Disqualifying disposition

If you sell your shares less than two years from the offer date or less than one year from the purchase date, the sale is a disqualifying disposition. You will pay taxes on short-term capital gains as an ordinary income according to your tax bracket.

ESPP Dividends

Many publicly traded companies pay out dividends to shareholders. If your employer pays dividends, they will automatically be reinvested in the company shares. You will owe ordinary income tax on your ESPP dividends in the year when you receive them. Usually, the plan discount does not apply to shares purchased with reinvested dividends. Additionally, these shares are treated as regular stock, not part of your Employee Stock Purchase Plan.

Investment risk

Being a shareholder in a solid high growth company could offer a significant boost to your personal finances. In some cases, it could make you an overnight millionaire.

However, here is the other side of the story. Owning too much stock of a company in bad financial health could impose a significant risk to your overall investment portfolio and retirement goals. Participating in the ESPP of a company with a constantly dropping or volatile stock price is like catching a falling knife. The discount price could give you some downside protection, but you can continue to lose money if the price continues to go down. The price of General Electric, one of the oldest Dow Jones members, went down more than 65% in one year.

Remember Enron and Lehman

Many of you remember or heard of Enron and Lehman Brothers. If your company seizes to exist for whatever reason, you could not only lose your job, but all your investments in the firm could be wiped out.

You are already earning a salary from your employer. Concentrating your wealth and income from the same source could jeopardize your financial health if your company fails to succeed in its business ventures.

As a fiduciary advisor, I always recommend diversification and caution. Try to limit your exposure to your company stock and sell your shares periodically. Sometimes paying taxes is worth the peace of mind and safety.

Conclusion

Participating in your employer’s Employee Stock Purchase Plans is an excellent way to acquire company stock at a discount and get involved in your company’s future.

Owning company stock often comes with a huge financial upside. Realizing some of these gains could help you build a strong foundation for retirement and financial freedom. When managed properly, it can help you achieve your financial goals, whether they are buying a home, taking your kids to college, or early retirement.

Keep in mind that all ESPPs have different rules. Therefore, this article may not address the specific features of your plan.

 

About Stoyan Panayotov

I am a fee-only financial advisor and the founder of Babylon Wealth Management. As fiduciary advisors, we provide bespoke wealth management and personalized financial planning to busy families in the Bay Area and nationally. Many of our clients are tech workers, physicians, business owners, professionals preparing for retirement and young families looking to build financial independence.

I started Babylon Wealth Management to help young families and successful professionals build, grow and preserve their wealth. Being a fee-only financial advisor, I never earn sales commissions or sell investment products. Furthermore, I am committed to acting in my clients’ best interest by providing trusted advice and bespoke wealth management solutions. I enjoy helping clients develop robust and personalized long-term financial plans to achieve their personal and financial goals.

After completing a bachelor’s degree in Accounting at Varna University of Economics in Bulgaria, at the age of 23, I moved to New York City to pursue a Master of Business Administration at Pace University. I was fortunate enough to have a full merit-based scholarship and finished graduate school with no student loans. Upon completing grad school, I joined the ranks on Wall Street for nearly two years. I specialized in risk management and option strategies for equity and fixed income products for Deutsche Bank and Wells Fargo. In 2006 I obtained a highly recognized CFA designation.

Living in New York without family support was a life-changing experience for me. II arrived at JFK Airport on August 24, 2002. I stayed in a hostel for two weeks and later moved in with three of my fellow Bulgarian students into a one-bedroom apartment in the Bronx. There was a time in life when all I owned was $200, just enough to pay for the next month’s rent. Many times, I contemplated returning to Bulgaria, but somehow, I always pushed through life’s adversities. I’ve learned to appreciate each moment, big or small, that life presents. These challenges have helped me develop strength and flexibility, which supports my practice as a financial advisor.

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