An employee stock purchase plan (ESPP) is a benefit offered by some companies that gives employees the opportunity to purchase company stock at a discounted price. Employees can save up to 15% on stock purchases through an ESPP. With an ESPP, employees contribute after-tax earnings through payroll deductions which are used to purchase company stock at the end of an offering period, usually every 6 months. The stock is purchased at either a 15% discount off the lower of the stock price at the beginning or ending of the offering period. ESPPs can be a great way for employees to become shareholders and benefit from the company’s growth. However, like any investment, there are pros and cons to weigh when deciding if participating in an ESPP makes sense.
What are the benefits of an employee stock purchase plan?
Here are some of the key benefits of participating in an ESPP:
- Purchase stock at a discount – The main perk of an ESPP is being able to buy company stock at a 15% discount off the lower of the starting or ending stock price for the offering period. This automatic discount makes it easier to get started investing in your company.
- Tax advantages – ESPP contributions come out of your paycheck before taxes, so you save money upfront on income taxes. You only owe taxes when you sell the stock in the future.
- Share in company growth – Owning company stock allows you to benefit from increases in the share price over time. As the company grows and performs well, the stock value should rise too.
- Low risk with short terms – ESPP offering periods are usually every 6 months. This short timeline reduces risk compared to locking up your money for longer periods.
- Low costs – ESPPs have minimal fees taken out compared to other investment accounts. Often, the only cost is the broker commission when selling the stock.
- Can sell immediately – You can choose to sell the stock purchase right away to secure the 15% gain if you wish, rather than holding the stock long-term.
What are the downsides of employee stock purchase plans?
While ESPPs can provide nice perks, there are also some drawbacks to consider:
- Not diversified – Since ESPPs only allow investing in your company’s stock, you miss out on the risk management benefit of diversification across other stocks and assets.
- Stock can go down – There’s no guarantee your stock will go up. The stock price could decline after purchase, resulting in a loss.
- Short term taxes – If you sell right away, profits are taxed as ordinary income versus the preferential long-term capital gains rates for stocks held over one year.
- Can’t control timing – You may be buying at a peak price since purchase dates are set and not in your full control.
- Lack of control over shares – Typically you must hold ESPP shares for 1-2 years before selling or transferring them into another brokerage account.
- payroll deductions reduce take home pay – Money put into an ESPP lowers your regular paychecks, so budget accordingly.
Who is an ESPP best suited for?
Generally, an employee stock purchase plan works best for these types of employees:
- Long-term outlook – You intend to hold the stock long-term to reap larger gains and believe in your company’s continued growth prospects.
- Already invest in company stock – You want to increase your holdings in company stock at a reduced cost.
- Max out other savings – You’ve already maxed out other tax-advantaged retirement accounts like 401(k)s and IRAs.
- Meet company match – Your employer has a generous match or contribution incentive for participating in the ESPP that outweighs the risks.
- Can tolerate risk – You have a higher risk tolerance and adequate emergency savings to withstand potential stock losses.
On the other hand, an ESPP may not be the best option for these employees:
- Need liquidity or diversification – You need quick access to your money or want a diversified portfolio.
- New employees – You haven’t worked at the company long enough to trust in their business model and stock performance.
- Retirement focus – You prioritize tax-advantaged retirement savings plans over brokerage investing.
- Low risk tolerance – You are very risk averse and uncomfortable with potential stock volatility.
How much should you contribute to an ESPP?
The optimal ESPP contribution percentage depends on your financial situation and savings goals. Here are some guidelines on ESPP contribution amounts:
- Contribute 1-10% of your paycheck if you are using an ESPP for supplemental stock investing but have other priorities for your money.
- Contribute 10-15% of your paycheck if you aim to maximize your ESPP benefits and build a large company stock holding.
- Never contribute more than you can afford after meeting other financial obligations like paying off high interest debt and establishing an emergency fund.
- Contribute more than the minimum needed to receive a company match, if one is offered. This allows you to enjoy “free money” from the employer match incentives.
It’s usually not recommended to put 100% of your investment dollars into company stock alone. Diversifying your assets is wise. But contributing something to your ESPP can provide nice tax-advantaged returns.
Should you sell your ESPP stock right away or hold long-term?
Whether to hold or sell your ESPP shares comes down to your reason for participating. Here are the pros and cons of each approach:
Reasons to sell right away
- Lock in 15% quick return – Get your near instant gain and reinvest the proceeds into other assets.
- Avoid overconcentration in company stock – Maintain a diversified portfolio.
- Have liquidity and flexibility – Money is not tied up long-term in one stock.
Reasons to hold long-term
- Let stock continue to grow – Believe in upside company performance and future stock price appreciation.
- Qualify for long-term capital gains tax rates – Get a lower tax rate on profits if held over one year.
- Avoid short-term trading fees – Broker fees add up if repeatedly selling every offering period.
Younger investors with a higher risk tolerance may favor holding for long-term growth. Older investors nearing retirement may prefer to play it safer and sell quickly to capture the guaranteed discount.
What are the taxes on ESPP shares?
Employee stock purchase plans have unique tax treatment. Here’s how ESPP shares are taxed:
- Payroll contributions – Since ESPP contributions come out of your pay pre-tax, they lower your taxable income for the year.
- Discounts – The 15% discount you receive on the stock purchase is taxable as ordinary income in the year of purchase. This discount will be included on your W-2.
- Dividends – Any dividends earned on the stock are taxed as ordinary income.
- Sale of shares – You owe capital gains taxes when the shares are sold based on the difference between the sale price and purchase price. Short-term capital gains rates (held under 1 year) are higher than long-term (held over 1 year).
Consult a tax professional to discuss how to optimize your ESPP taxes.
How does an employee stock purchase plan work?
Here is an overview of how a typical ESPP works:
- Enroll in the ESPP – Employees elect to participate and authorize after-tax payroll deductions to fund the stock purchases.
- Offering period begins – This 6-24 month cycle starts the accumulation of payroll deductions to use for stock purchase at the end of the period.
- Stock price set – The beginning price (or grant price) is set at either the start of the offering period or the purchase date. The end price is the stock’s closing price on the purchase date.
- Money accumulates – Payroll deductions are gathered in an account to use on the purchase date.
- Stock is purchased – On the purchase date, accumulated funds are used to buy company stock at the discounted price. The shares are then deposited into the participant’s account.
- Next offering period starts – The process begins again for the next cycle.
Employees must enroll and participate during the offering period to enjoy the 15% discount price on the stock purchase date.
What are strategies to maximize ESPP benefits?
Here are some tips to optimize your ESPP participation:
- Understand your plan details – Review the plan documents to know key terms like purchase dates, contribution limits, holding periods, etc.
- Take full advantage of the discount – Contribute enough to get the full 15% discount on stock purchases.
- Consider tax implications – Understand the tax impact, especially if selling immediately instead of holding long-term.
- Be aware of fees – Check for any flat quarterly or annual fees. Many plans just charge minimal trading commissions when selling.
- Sell strategically – Either sell quickly to capture the discount or hold longer for capital gains rates.
- Monitor stock price trends – Pay attention to company performance to inform your sell decisions.
- Diversify your portfolio – Balance ESPP stock with other investments.
- Maximize other tax-advantaged accounts first – Make sure you earn any 401(k) match and fund an IRA before prioritizing extra ESPP contributions.
Employee stock purchase plans can provide a nice opportunity to buy company shares at a discount. This perk allows employees to gain equity and benefit from upward stock price movement over time. However, participating does concentrate your investment in your employer’s stock and carries risks of volatility. Review your financial plan and risk tolerance to decide if an ESPP aligns with your goals and makes sense for your situation.