We’re fielding questions about Employee Stock Purchase Plans (ESPP) more and more it seems. More often than not, these offerings are made available by mid-size to large, well established, publicly traded companies as an additional incentive for long-term savings in the form of stock ownership. It’s tough to balance or prioritize savings dollars for employees between this vehicle and the more traditional 401(k), so we wanted to break these plans down to provide some clarity and direction on the best way to utilize these offerings if they are made available to you.
How Do Typical ESPP’s Work?
Simply put, an Employee Stock Purchase Plan is an employee benefit plan. It allows employees of the company to purchase shares of its company stock at discounted prices. This discount can range in value, but for purposes of example, we’ll assume a 15% discount is made available in this article. While qualified and non-qualified plans exist, we will focus on non-qualified plans here as well. They tend to be more prevalent in the marketplace.
Per example, a company can offer employees the ability to purchase company stock at a 15% discount below the market price for shares of that stock. Typically there is an offering period (3 months or 6 months) in which the client can elect to have payroll deductions made into a side account for purposes of purchasing these shares of stock at the end of the offering period (purchase date). If the offering period is 3 months, for instance, the employee will have money withheld from his/her paycheck throughout that 3 month period. At the end of the 3 months, on the purchase date, shares of stock are purchased at a 15% discount below market value.
There are limits to these plans. Most are imposed by the company offering the ESPP, but the IRS does have a $25,000/yr limit as a maximum contribution an employee can make in one calendar year.
How Are ESPP Shares Taxed?
The tax rules are pretty complex. The discounted value (in this case 15%) is typically taxed at earned income rates. It’s essentially as if the employee were receiving additional compensation in the value of this discount.
This is where the fun starts! Once purchased, the market value of the stock itself begins to shift. If the stock value increases, capital gains are created within the shares themselves. These gains are eligible for long-term capital gains rates if the shares are held by the employee for at least 1 year prior to sale. This growth will only qualify for short-term capital gains rates (at earned income rates) if those shares are sold within the first year of ownership.
Should I Contribute To My ESPP?
Absolutely! If an ESPP is part of your compensation package, then you should take advantage! I encourage clients to contribute as much income as they can up to the maximum (either plan maximum or IRS $25,000/yr maximum) contribution amounts. The discount represents free money! Take advantage of it.
Worst case scenario, you have to liquidate your shares immediately upon purchase and use the money to fund your household budget. In this case, you’ve just received $1 for the cost of $0.85. It’s a no brainer...it just requires moving money around from your ESPP custodian back to your family checking account.
Best case scenario, your family can thrive within the confines of the money leftover after both contributions are made. In this case, using the ESPP custodian either to hold the shares of company stock or sell the company stock to diversify your investment strategy adds an additional element of long-term savings to your family’s financial plan.
Either way, there aren’t many arguments that can be made for not contributing to this plan if the discount is great enough. The only real disadvantage is that the money withheld from your paycheck typically won’t become available to you until after the shares have been purchased at the end of the offering period. Typically this is 3 months or 6 months but varies from plan to plan.
Should I Contribute To My ESPP Instead of My 401(k)?
We get this question a lot. And we get it! You only have so much money. However, there is absolutely no correlation or decision to be made here. Fund your 401(k) at appropriate levels first based on the retirement plan and goals you set with your financial advisor. This money is for your future.
Regardless of how you set your 401(k) contributions, take advantage of your ESPP. Take advantage of it even if you aren’t left with enough money in your paycheck to cover your family expenses. In an ideal world, you are able to let the shares of stock grow or become part of a longer-term savings strategy, but if those dollars are needed today, they can be used as soon as they are credited to your account. By “shrinking” your paycheck, you are actually increasing your family’s take-home pay by 15% of every dollar you choose to contribute. Think about that!
If I Don’t Need To Cash In My Shares, Should I Continue To Invest Them In Company Stock?
This requires more context within your family’s financial plan. Generally speaking, there are risks to investing too much of your family’s future in your current company stock. Your company provides your paycheck. As we just saw during the COVID-19 pandemic, unforeseen circumstances can take their toll on any industry for reasons we can’t anticipate. The risk of macroeconomic forces wreaking havoc on your company may put your steady paycheck and your long-term savings at risk all at the same time if your portfolio is too heavily saturated with company stock!
Diversification is key. For a lot of people with ESPP plans, we recommend selling shares (or holding them until the 1 year mark if they contain gains that may qualify for long-term capital gains treatment) and blending the cash into a more diversified investment strategy.
As always, if you want to talk about your financial plan or get a second opinion on how you should be using resources your company provides, don’t hesitate to schedule some time to chat!