ESPP or employer stock purchase plans, as they’re commonly known, are a common employee benefit within the tech industry. As the name implies, they allow employees to purchase stock of the company at a discounted price. For example, rather than purchasing the stock outside of the plan for the market price, ESPP’s might apply a 10 or 15% discount to the current price, essentially locking in an immediate return of 10-15% (before taxes). Of course, determining where contributions to an ESPP plan fall on the priority list between other goals such as retirement account contributions, college savings, a vacation home, etc., is where careful analysis and financial planning come into play. This article will discuss ways to maximize an ESPP plan based on the unique characteristics, individual financial situation, tax-efficiency, among other considerations!
Timeline
ESPP’s have two general time periods to be aware of to evaluate them. Let’s get these two basic definitions out of the way before diving deeper.
Offering period: The period of time when cash is set aside from your paycheck into an account (held as cash) in anticipation of an eventual purchase of company stock. Offering periods typically range from 3 months to 6 months, though some plans may even be as long as a year.
Purchase Date: The date when funds are used to purchase company stock using the discount percentage.
Is Your ESPP qualified or non-qualified?
ESPP’s have two configurations when it comes to being “qualified” or “non-qualified,” according to IRS tax code section 423. Qualified ESPP plans don’t require tax payments on the difference between the stock’s purchase price when applying the discount and the current fair market value. You’ll also never owe social security or medicare taxes on stock purchased with a qualified ESPP plan, even at the sale of the stock.
Non-qualified ESPP plans don’t offer the same tax-advantages described above. However, a company may decide to employ this type of plan to increase the discount percentage, company matching contributions, and/or limiting the plan to a select group of employees.
The vast majority of ESPP plans fall under section 423 qualified plans. Nonetheless, being aware of the type of plan your company offers is important to ensure you’re able to maximize it.
Tax Considerations of ESPP’s
As with any financial strategy, we must always consider the tax ramifications of our decisions. ESPP’s are no different; understanding how they’re taxed helps maximize them based on your unique situation. The following table helps break down the differences in taxation for qualified ESPP and non-qualified. The other important distinction is the difference between a “disqualifying disposition” and “qualifying disposition”, not to be confused with whether the plan fits section 423 of the tax code. Disqualifying dispositions are simply sales of the purchased stock that occur within 1 year of the purchase date and/or 2 years of the beginning of the offering period (when cash is set aside to make the eventual purchase within the plan). Qualifying dispositions are when the stock sale occurs more than 1 year from the purchase date and 2 years from the start of the offering period. The key difference between the two is whether you pay short-term capital gains tax or long-term capital gains tax. The longer holding period required, potentially small tax benefit, and inability to diversify away from the stock oftentimes make shooting for a qualifying disposition a less attractive option.
What if my company’s stock outlook isn’t great?
The beauty of ESPP plans is the majority will allow you to sell the purchased stock immediately upon purchase. Therefore, when you apply the discount and sell your company stock immediately, minimal risk occurs. You’ve essentially locked in the discount price as an immediate gain (ignoring tax consequences though still a health gain with a 15% discount). If your plan allows purchases every quarter or every 6 months, a gain of 10 or 15% is tough to beat with minimal risk by employing a sale at purchase strategy. In other words, regardless of whether your company stock is performing well or not, if you sell the stock immediately at purchase, you’ll still benefit.
Another way to view an ESPP plan is to use it as a short-term savings vehicle. ESPP plans hold your cash in a separate account until the purchase date is reached; therefore, the cash set aside for purchase has zero risks associated with the market. Most plans even allow you to pull the cash before the purchase date if necessary. When the purchase date arrives, the cash is used to purchase the shares using the discount percentage, the shares are sold, and all of a sudden, you have 10 or 15% more cash than you would have otherwise had in the short period of time. This cash can then be diversified elsewhere or used for various other goals.
Other Key Considerations
Qualified ESPPs oftentimes have a key attribute known as the “lookback provision”. The lookback provision allows participants to use either the purchase date price or the beginning of the offering period price of the stock when applying the discount. This is extremely beneficial because if the stock price has had a significant increase during the offering period, the participant will ultimately purchase many more shares with the same dollar amount using the lower stock price at the beginning of the offering period. For example, if the stock price is $10 on January 1st (the beginning of the offering period) and $20 on June 1st (the purchase date), the lookback provision will apply the 15% discount to $10, instead of $20. If the participant contributed $5,000 to the plan during this period of time, they’d receive 588 shares ($10 *.15 = $8.50 discounted purchase price. $5000/8.50 = 588 shares) of company stock. If a lookback provision didn’t exist, they’d receive 294 shares ($20*.15 = $17 discounted purchase price. $5000/$17 a share= 294 shares).
Oftentimes, ESPP participants are also compensated with other company stock in the form of stock options or RSU’s. If the goal is to maintain a particular percentage of the overall investment portfolio in company stock, which “bucket” of company stock is most preferable to hold? In most cases, that will likely be RSU’s or exercised stock options because the holding period for long-term capital gains is shorter. However, if those aren’t a consideration, ESPP plans can be a way to build up an allocation to company stock. It’s important to be aware of the risk holding too much company stock can pose, though, as we oftentimes feel insulated from that risk as employees of the company and a natural tendency to feel we have control over the stock price. In reality, we exercise very little control or understanding over the direction of stock prices in the short-term. Maintaining a diversified approach to long-term investments is, and always will be, a viable, winning strategy.
The Bottom Line
If you’ve got access to an ESPP, it’s important to consider the plan’s unique benefits. Determine how it fits into your financial situation and whether it can help bolster progress towards your goals. If you need assistance in evaluating your company’s ESPP plan and how it fits into the large picture, schedule a free consultation today.
