In addition to the common 401(k) plan, employers may offer what’s known as an employee stock purchase plan, or ESPP for short. The plan allows employees additional benefits beyond the 401(k). If offered by your company, it’s almost always a good idea to participate.
How Employee Stock Purchase Plans Work
All ESPPs have a few things in common. First, an employee must elect how much to contribute. Typically its the lesser of 15% of gross income or $25,000 annually (IRS limit). Contributions are after-tax payroll deductions. Meaning it will come directly from your paycheck. However, there aren’t any tax benefits.
The major benefit of ESPPs is they allow employees to buy the company’s stock at a discounted price. Most often at a discount of 10-15% of the market value! That means you immediately have a positive return on your investment when participating in an ESPP.
Offering Period
Employees can elect to participate during the offering period. Depending on your companies unique plan, offering periods may overlap, or run consecutively.
Your contributions are accumulated in a separate account. Company stock is not bought during this period, funds are merely accumulated to ready for purchase.
Offering Date
The first day of the offering period. Used for tax purposes.
Purchase Date
At the end of the offering period is the purchase date. On this date company stock is bought for all participants at the discounted price.
One caveat to be aware of is the “look back provision”. Most companies include this benefit. Instead of purchasing the stock at the purchase date market price, the plan will purchase the stock at the lesser of either the offering date or purchase date market price.
For example, if ABC companies stock was $100 on the offering date and $120 on the purchase date, the plan will use the lesser ($100) to calculate the discounted purchase price from.
This is a huge advantage. It means you are receiving more shares, at a better price. Shares become accessible to employees the day after the purchase date.
Example for ABC company ESPP:
The plan offers employees to purchase ABC stock at 15% discount. For this example, let’s say an employee has contributed a total of $10,000 during the offering period.
Offering date market price of ABC stock: $100 per share
Purchase date market price of ABC stock: $110 per share
Your purchase price: $85 (lesser of offering date price and purchase date price, $100 * 15%)
Total shares purchased: 118 (rounded up for the sake of simplicity)
Gain: $110 (current market price) – $85 (discounted purchase price) = $25 per share
$25 per share * 118 shares = $2,950 profit
This is equal to a 29.5% gain. Not bad at all. Let’s test what happens when the stock price is less on the purchase date than the offering date.
Offering date market price: $100 per share
Purchase date market price: $90 per share
Your purchase price: $76.5 (lesser of offering date price and purchase date price, $90 * 15%)
Total shares purchased: 131 (rounded up again)
Gain: $90 (current market price) – $76.5 (discounted purchase price) = $13.5 per share
$13.5 per share * 131 shares = $1,768.50 profit
This is equal to a 17.69% gain. Again, not bad. Even when the stock price goes down after the offering date, because you are purchasing at a 15% discount, you’re still locking in a positive gain. Extrapolate this over a longer period of time and you can see how it can be used as a great wealth building tool.
When to sell shares?
The “downside”, of an ESPP, is that employees tend to hold their shares too long. If you participate in a plan over a long period of time, without selling any stock, it’s likely a large part of your net worth will be concentrated in the company’s stock. While buying and holding the company’s stock may have helped build wealth over time, it can also be lead to disastrous outcomes.
Diversification is still key to maintaining wealth. Understandably, employees tend to get emotionally attached to their company’s stock. They become overconfident and lose sight of what the real risks are.
A concentrated position does not maximize an investor’s returns to the level of risk they are taking. Using diversification, you can still earn solid returns that may or may not equal the performance of company stock, but it will greatly reduce the risk.
The worst possible scenario is building up a million dollar portfolio of company stock only to have an event occur that sends the stock plummeting. It can and will happen to companies. The best defense is to keep emotion out of the equation and diversify your investments.
A great strategy with ESPPs is to sell vested shares immediately after the purchase date. By doing so you’re guaranteeing a positive return and ability to diversity.
Tax Consequences
Calculating the tax consequences of selling ESPP shares can be complicated. Depending on the length of time you hold the shares you either have qualifying dispositions or disqualifying dispositions.
Qualifying Dispositions: For stock held 2 years after offering date, and 1 year after purchase date. The discounted percentage is taxed as ordinary income and the remainder of stock is taxed at long-term capital gain rates.
Disqualifying Disposition: Majority is taxed as ordinary income.
Even with the favorable tax treatment of holding shares for a longer period of time, in most cases, it’s better to take the profits and put the cash to work in a diversified portfolio.
Conclusion
You should absolutely participate in your employer’s employee stock purchase plan if available. The ability to purchase stock at a discount with no commission fees is a major advantage. If your company offers this benefit I encourage you to learn more about your specific plan and participate! If you have specific questions about your plan feel free to schedule a free consultation with us today.