An employee stock purchase plan (ESPP) can help employers promote loyalty among employees while allowing those same employees to participate in the success of the company they work for. In many ways, an ESPP can be a win-win situation for both everyone involved. There are many benefits to owning part of the company you work for. If you know that the company’s performance is connected, in some way, with your own financial well-being, you’ll be more likely to give your all and help the company succeed. You’ll also do your best on the job so you can reap the benefits of improved, value-added performance that directly impacts the bottom line for both yourself and your employer. Scared to invest in the stock market? Many times, an employee stock purchase plan (ESPP) can remove some of the guesswork and uncertainty around investing in the stock market. In this situation, you are investing in a company you’re familiar with with an added bonus of an automated, regular approach to setting aside money to invest in assets that are, very often, discounted from market prices. A bonus is that there are no commission fees associated with purchasing the stock, further adding to the savings aspect of participating in this type of stock purchase. With this approach, you are investing in a company that you are intimately acquainted with but at a better price than the market currently offers. This is an ideal situation that is difficult to duplicate for even the most seasoned investors. Depending on the type of plan you participate in, there may also be some tax advantages when it comes to realizing income associated with cashing out your company shares. In order to receive favorable tax treatment for your ESPP income, you’ll have to meet certain requirements. Because the rules and regulations around ESPPs are very specific, you should know as much as you can about this employment benefit before choosing to participate. In general, an ESPP can be a useful tool in your wealth-building arsenal. Here are some things you should know before you decide to invest in your company’s Employee Stock Purchase Plan.
Though each company will have its own method of administering their employee stock purchase plan (ESPP), there are some common practices and terms that you should be familiar with to help you research and ask questions. This will help you get clarification on confusing concepts and hopefully guide an informed decision on how to participate.
This can coincide with the enrollment period or when you sign up to participate in the company ESPP, but it doesn’t have to. During this time, you’ll be accumulating payroll deductions that will be later used during the purchase period, also known as the exercise date.
This is the time frame when your employer purchases company stock on your behalf. The money will come from the funds you’ve accumulated with your payroll deductions during the offering period. There can be multiple purchase periods within a single offering period.
There are two types of ESPPs: qualified and unqualified. A qualified employee stock purchase plan (ESPP) can also be called a “section 423 ESPP,” referring to the IRS tax code section that gives special tax treatment when realizing income from the sale of ESPP shares. Nonqualified plans are not recognized by the IRS for special tax treatment. Because most ESPPs are qualified, most of this discussion will pertain to this type of ESPP.
As mentioned, if you are participating in a qualified employee stock purchase plan (ESPP), you can reap the benefits of tax-advantaged treatment. However, the tax treatment will depend on a few factors such as the bargain element (difference between market price and purchase price on the purchase date) and when you buy and sell shares. The income from selling your shares will be categorized as either capital gains or ordinary income. The tax category depends on when you sell or “dispose” of the stock. Making a “qualifying disposition” or a “disqualifying disposition” will determine the taxes you’ll pay on your profits. A disqualifying disposition means you sold the stock within two years after the offering date or one year (or less) from the purchase date. In this case, your employer will report the bargain element on your W-2 and the profit is taxed as ordinary income. A qualifying disposition means that you sold your stock at least two years after the offering and at least one year after the purchase date. In this case, only the bargain element is considered ordinary income for tax purposes. Any profit beyond that is considered long-term capital gains. Capital gains are taxed at lower rates than ordinary income. For more information on employee stock purchase plan tax treatment and qualified plans, you can refer to this full explanation on the Government Publishing website. Another helpful resource is this quick guide on ESPP tax treatment from the H&R Block website.
Perhaps the most attractive aspect of purchasing stock through an ESPP are the prospects of getting stock below market prices. Discounts on company shares can be as high as 15%, but additional discounts can be applied if the company offers a lookback provision. This provision means your actual discount will be the lower of either the price at the start of the offering period or on the purchase date. For example, let’s say your company’s stock price is $10 a share at the start of the offering period. Then, the price rises to $12 by the end of the offering period and when a purchase date occurs. Your 15% discount is based on the lower price of $10, even though it’s trading at $12 on the purchase date. Now, you are getting a $12 stock for $8.50 which is a 29% discount off the market price. This is not a bad deal at all!
Though there seems to be many advantages to participating in an ESPP, you shouldn’t go into it blindly or just because everyone else in your company is doing it. You should research this investment like you would any other stock and know exactly how it will play into your short-term and long-term financial goals. Here are some questions you should ask yourself before you enroll in your ESPP.
Though the discounts and tax advantages of buying stock in an ESPP can be a powerful investing incentive, you still need to consider the company as a whole. Andrew Wang is a managing partner at Runnymede Capital Management, he urges would-be ESPP participants to fully evaluate their company’s stock before investing. “As with any investment, you should research your company’s historical returns, value, and future growth prospects that can affect the share price.” Wang adds, “If you’d consider buying your company without an ESPP, there’s a good chance that the discount, typically 5% to 15%, makes for an attractive benefit.”
Investing in an ESPP can be a good idea, but it should complement your financial goals. These goals can be either long-term or short-term objectives for your overall financial health. Depending on when you buy and sell your shares, your ESPP could fit well into both. For some, these shares can provide a quick profit for needs like debt repayment or a home renovation. For others, this money may help fund their children’s or grandchildren’s education. An ESPP can also provide a back up plan for someone whose main source of income shifts from salary to self-employment. Newly separated from her employer, Liz Abunaw is thankful for the added layer of security her discounted stock stash provides as an entrepreneur. “I participated in my company’s ESPP as soon as I was hired. I contributed 2% in post-tax income. Over the course of my two years of employment, that bought me 135.5 shares that are now worth almost $13,000. I paid $7496.70,” says Abunaw. Liz goes on to explain, “Now that I’ve made the move to entrepreneurship I am so happy to have these shares in my back pocket. Not only did I buy them with a built-in return (10% discount on fair market value), but I’m capturing all of the growth too.” As you can see, there can be plenty of ways to use your ESPP shares, but be very clear on the objective so you can be smart about how much your purchase and what the proceeds will be used for when it’s time to cash out.
If ESPP shares make up a large portion of your investment portfolio, you could be exposing yourself to more risk than necessary. Of course, there’s a chance that your company stock will do well, but there’s always a chance that the stock’s performance could decline — leaving you with losses. Jeffrey Skinner-Perkins is a certified financial coach and real estate agent. He says people should think about events that could negatively impact stock purchased via an ESPP, “Even with the discounted share price offered through the ESPP, the discount may be negated by a downward shift in price at any point during the lifespan of the investment.” In addition, there are other factors, aside from falling stock prices, to consider that could also offset or minimize the discount like commissions on sale transactions and taxes. Not to mention, a lack of diversity in assets could cause a major decline in net worth for someone solely invested in their company’s stock.
Generally speaking, it’s a good idea to have a diversified base of investments. So it’s best to think of your ESPP as an add-on to an already-diversified investment strategy. Make sure you understand exactly how your company’s ESPP plan is administered so you can play by all the important rules, maximize your discounts and earnings while staying compliant with your tax obligations. Overall, a qualified ESPP can be a positive addition to your wealth-building strategy. Hopefully, you’re now armed with information that makes you a savvy investor — even when it comes to purchasing your company’s own stock.