What is 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 schedule. 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 ESPP 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 and look-back provision
Offering periods of most ESPPs are ranging from 6 to 24 months. The longer periods could have multiple six-month periods for purchase. Your employer will use your salary contributions that accrue over time to buy shares from the company stock on your behalf.
Most ESPP offer a look-back provision will allow you to purchase the shares at a discount from the lowest of the beginning and ending price of the offering period.
For 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.
Selling your ESPP shares
Some ESPPs allow you to sell your shares immediately after the purchase date, realizing an instant gain of 17.65%. Others may have a holding period restriction during which you cannot sell your shares. Find out from your HR.
An ESPP plan has its own unique set of tax rules. All contributions are pretax and subject to federal, state and local taxes.
Keeping your stock will not a 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 tricky.
The discount is treated as ordinary income
The first to remember is that the price discount is always treated as ordinary income. You will add the value of the discount to your regular annual income and pay taxes according to your tax bracket.
The difference between the selling price and the purchase price is considered a realized capital gain. There are two types of capital gains – short-term and long-term. Short-term gains are triggered if you sell your stocks in less than one year after the purchase date. You will pay taxes on short-term capital gains as an ordinary income according to your tax bracket.
Long-term capital gains vary between 0%, 15% and 20% depending on your income. In order to get preferential this lower rate from the IRS, you need to keep your shares for more than 2 years from the offer date and 1 year from the purchase date.
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 a 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 longest 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.
Participating in your employer’s ESPP is an excellent way to acquire company stock at a discount and get involved in your company’s future. While risky, 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 many that most ESPPs have different rules. Therefore, this article may not address the specific features of your plan. If you’d like to discuss how to make the most out of your ESPP, please feel free to reach out and learn more about our fee-only financial advisory services. I will meet you in one of our offices in San Francisco, Oakland, Walnut Creek, and Pleasant Hill areas. As a CFA® Charterholder with an MBA degree in Finance and 15+ years in the financial industry, I am ready to answer your questions.
Stoyan Panayotov, CFA
Founder|Babylon Wealth Management