A 401(k) match is additional money your employer adds to your 401(k) when you contribute a certain amount, up to a percentage of your salary. Some people refer to this as “free money”: you don’t have to anything to earn it other than contribute to your retirement plan.
Another valuable source of this “free money” is an Employee Stock Purchase Plan (ESPP). However, not many people use it. In fact, while many mid and large-size companies offer an ESPP, less than 50% of those eligible employees actually participate.
In this blog, I’ll share more about the benefits of an ESPP, including how they are taxed and if they are worth participating in.
What is an Employee Stock Purchase Plan?
An employee stock purchase plan, or ESPP, is a company program that allows employees the option to purchase company stock, often through payroll deductions. These shares of stock are usually offered at a discount, between 5% – 15%.
Eligible employees are allowed to opt into the ESPP program twice during a 12-month offering period. During the enrollment period, you decide what percentage of your income (usually up to 15% or $25,000 annually) you are interested in allocating towards buying your company’s shares.
The percentage or dollar amount consistently withheld from payroll will be used to purchase the discounted shares at the end of the period. This is called the purchase date. Most commonly, a plan’s purchase date occurs once every 6 months.
Here is an example:
This year, you elect to contribute the maximum $25,000 ($12,500 x 2 enrollment periods) to your company’s ESPP within the 12-month offering period. At the start of the first 6-month enrollment period, your employer withholds $12,500 from payroll and sets it aside. At the first purchase date 6 months later, your company buys you 250 shares at a stock price of $50 per share. This is your first of two $12,500 contributions.
Now consider the discount (15% in this case).
Your $50 per share is now $42.50 per share, giving you just over 294 shares vs. 250. A huge benefit to you.
Some ESPPs offer a “lookback provision,” which can further enhance your benefits. In an effort to maximize your discount, a lookback provision offers you the option to purchase your discounted shares at the lower of either the stock price at the beginning or the end of the offering period.
Expanding on the previous example:
The stock price is $40 per share at the start of the period and it increases to $50 per share by the end. 15% of the lower $40-per-share stock = $34 per share. Your $12,500 now buys you >367 shares compared to the original 250. That is nearly a 50% increase in the number of shares you can buy, just by leveraging the discount and lookback provision!
How are ESPPs Taxed?
As good as ESPPs might sound, they don’t come without their tax implications. Taxes are due upon the sale of your shares, and timing matters because it determines whether you pay short-term capital gains or long-term capital gains rates.
Qualifying Position
To incur long-term capital gains, you must meet two requirements:
- Hold shares for at least 1 year after the purchase date.
- Hold shares for at least 2 years from the start of the offering period.
*Keep in mind that the discount you received on the purchase of the shares is considered taxable income and is still taxed as ordinary income, regardless of the holding period.
In our previous example, we bought shares for $34, which is a 15% discount of the $40 share price at the start of the lookback provision. That $6 per share is taxed at your short-term capital gains rate (ordinary income tax rate). Upon meeting the qualifications above, should your stock reach $80 per share when you sell, you pay the more favorable long-term capital gains rates on the remaining $40 gain.
Disqualifying Position
A disqualifying position occurs when you do not meet both of the requirements above. If both are not met at the point of sale, usually, the entire gain will be taxed at your ordinary income rate.
Are ESPPs Worth It?
17.6% returns are hard to come by, but ESPPs can offer you this unique benefit. However, proper execution of the sale of your shares obtained through ESPP is critical to maximize this benefit.
Let’s revisit once more our example from above:
Your $50 shares at a 15% discount equates to $42.50 per share.
Return = ((Market price – Discounted price) / Discounted price)) * 100
= (($50 – $42.50) / $42.50) * 100
= ($7.5 / $42.50) * 100
= 17.6%
It’s important to note that this return is realized only if you decide to sell the purchased shares immediately after acquiring them. The actual return on investment may vary depending on future performance of the stock and the timing of any subsequent sale.
Your unique financial situation dictates which path is right for you. Do you sell right away to lock in the gain and beef up your emergency fund, offset childcare, or pay off debt? Maybe, if the extra cash helps with cash flow needs. Do you hold the position, lock in long-term capital gains, and risk gains or losses in the stock value? Maybe, if you’d like to capture greater exposure and ownership in your company. As a highly compensated employee, you may have access to other compensation benefits, including employee stock options and restricted stock. In situations like this, it is important to be mindful of the risks associated with overconcentration in company stock.
Remember that there may be added risk by holding and allocating a significant portion of your portfolio to your company’s stock. It is important to ask yourself: Would I hold X amount of this company’s stock if I didn’t work here? A general rule of thumb is to consider holding around 5% of your portfolio in an ESPP.
Some ESPP plans can have different rules, so read your official plan documents carefully and ask your team of professionals to clarify details.
In the context of your overall financial plan, we must weigh the investment, tax, and behavioral considerations that determine the best use of this tool.
To learn more about how to maximize the potential of your employee stock plans, schedule a call with our team of advisors today. We welcome the opportunity to help you.
