Employee Stock Purchase Plans (ESPP)

Employee Stock Purchase plans (ESPP) are offered to nearly every employee of a publicly traded company. Yet, most of us don’t take advantage of them.

ESPP typically offer a 15% discount on purchase price or purchase price at the beginning of the period, (whichever is cheaper), incentivizing employees to take part in the long-term financial future of the company. If your company offers an ESPP, it could be a powerful part of your savings and investment portfolio. Plus, with numerous investment strategies available, ESPP can pay off in many ways.

At the same time, ESPP add tax complications, may result in stock overexposure if you already receive a significant portion of shares through your contract, or otherwise add to your income tax and raise you into a higher tax bracket.

Understanding how ESPP affect your entire financial security and savings is critical when considering investments. The experts at Tangent Retirement can help you to evaluate ESPP options and to work them into your financial planning in a way that best suits your specific personal needs.

What are ESPP

Employee Stock Purchase Plans are regulated plans offering employees of a publicly traded company discounts on stock, within certain terms. Some of the most common terms include:

Employees who own more than 5% of company stock may not participate (E.g., the CEO).

The IRS restricts the total dollar amount for an ESPP to $25,000 per year.

Most employers cap ESPP programs to 10% of payroll.

ESPP purchases are normally deducted directly from payroll and taxed as income.

Companies offer up to 15% discounts on ESPP programs, this may be lower.

Some ESPP allow for same-day sale.

Rollback Functionality – Your ESPP may offer rollback rates. This means you can purchase the stock for the price now minus the 15% or the price at the start of the period, minus 15%, whichever is cheaper. Any subsequent gains will be taxed.

Check Discounts – Not all employers offer a 15% discount. It’s important to pay attention to total discounts versus tax to determine if ESPP are right for you.

Offering Period – When you accumulate payroll deductions to purchase company stock. This typically aligns with the start and end of the year, but might not.

Purchase Period – The time-frame in which company stocks may be purchased, typically a 12 or 6-month period.

Taxes for ESPP

Discounts on stock (e.g., the 15% reduction) are taxed as income tax in the year of stock purchase. Any gains are taxed as ordinary capital gains. However, ESPP taxes are complex. Most should not attempt to use ESPP as part of their strategy without financial and tax advice and planning. For example, qualifying dispositions are taxed as capital gains. Unqualifying dispositions are taxed as income, meaning it may be too high to be profitable.

Employee Stock Purchase Strategies

Employee stock purchase strategies can vary considerably depending on income, terms of the ESPP, and portfolio. Here, most employees have two primary ESPP strategies:

Same-Day Sale

Some ESPP plans allow for same-day sale.

This means you can purchase a share at a 15% discount or 15% discount from the start of the period and turn around and sell it same day. In most cases, you can do this once each ESPP period, or twice per year in most companies.

If your income is $65,000 and your ESPP caps total shares at 10% of payrolling per period, you can purchase $6,500 of shares per period or two times per year. You can then immediately divest this for a profit of $975 less the added income tax (22% of the 15% discount, in this case $214), plus capital gains tax (15%, or in this case $146). In this case, you’d earn $615 per period, or a 9.46% return. The higher your income and the more stock you can purchase, the more worthwhile this is. However, some organizations will frown on the practice and you may not be allowed to do so. In addition, IRS taxes can become complicated, especially if you purchase over divestment limits.

Investment

Many ESP plans do not allow for same-day sale.

In this case, investment may still be a highly advantageous option.

Using the same salary as above, you could purchase $6,500 of stock for a year-period. With a 15% discount with rollback, and a 3.4% increase in stock value since the start of the period, you could receive a total of a 18.4% discount on stock. This results in an immediate capital gains well-exceeding the average performance of most indexes.

Planning Your Portfolio with ESPP

ESPP can be a powerful way to invest in stocks while reducing total costs. However, investing in ESP will increase income tax for the year of investment and will add to capital gains tax thereafter.

It’s crucial to sit down with a tax planner to determine how investments will impact your income tax. For example, if ESPP purchases push you into a new tax bracket, it may not be worthwhile.

On the other hand, if your company stock is showing long-term improvement, remains stable over time, and is otherwise secure, ESPP is a very good investment option. Of course, you probably don’t want too much of your portfolio to be company stock. Stock is volatile and adds risk to your portfolio. In addition, most people want to diversify stock holdings to minimize risk. Therefore, you should work out your ESPP with a portfolio management professional, who can guide company stock purchases as part of your overall saving or retirement strategy.

Employee Stock Purchase Plans have pros and cons. Individual plans can also vary a great deal with different discounts, terms, and offerings. In some cases, it may be possible to max out your stock option for each period and immediately divest. On the other hand, those same stock options may represent much more value in your 401(k) or other investment strategy over the long-term. The only way to find out is to do a comprehensive analysis of your tax and financial situation to determine how best to leverage the ESPP for your needs.