Stock Options

Understanding the Employee Stock Purchase Plan (ESPP)

Should you join your company's employee stock purchase? Is it wise to invest in an ESPP? Would you buy a $100 bill for $50 if you had the opportunity to? We’re sure you’d say yes! The same can be true if you're a part of your company's Employee Stock Purchase Plan. If you can afford it on a monthly cash flow basis, you should take advantage of the opportunity.

Understanding the Employee Stock Purchase Plan (ESPP)

What is an Employee Stock Purchase Plan (ESPP)?

An ESPP is an employee perk offered by most publicly traded companies that allows you to acquire shares of your company's stock at a discounted price. The most significant benefit of Employee Stock Purchase Plans is the discount!

You should expect a discount of between 5% and 15% from most employers—obviously, the more significant the discount, the better! These shares can then be sold immediately (if your company has a "Quick Sale" program), giving you a handsome profit with no risk. Because of this discount, you can use an ESPP to boost your savings.

There are specific regulations about how much and when you can contribute. How the shares are taxed when sold, and other logistics that we'll go over later, but for now, keep in mind that an ESPP allows you to buy shares of your company's stock at a discount and then sell them, locking in a nice profit.

ESPP important takeaways
What is an ESPP?

How does an ESPP work?

Under an ESPP program, employees can defer salaries and bonuses up to the IRS maximum of $25,000 per year (the "Contribution Limit"). During an initial "Enrollment Period," you choose how much to contribute per pay period.

This money is used to buy shares at a discount of up to 15% at the end of the enrollment period, which is usually every six months. This discount is frequently applied via a "Lookback Period," in which shares are purchased either at the beginning of the enrollment period (the Offering or Grant Date) or the end of the period (the Exercise or Purchase Date), whichever is lower. 

A typical ESPP timeline will resemble the one shown below.

How an ESPP Works
Source: Vincere Wealth

Enrollment Period

Typically, your ESPP will have an enrollment period every six months. You'll choose whether or not to participate in the plan and how much to contribute to it each pay period. Each pay period, your contributions to the plan will be deducted straight from your paycheck and deposited into your ESPP account. The money will be used to buy shares of your company's stock at a discount to its market value at the end of the period, on the purchase date.

Now, there are two ways that a discount can be applied to plans with a "Lookback Period."

Lookback Period

Your shares are purchased at a discount to market value on the Purchase Date (at the end of the Enrollment Period) or at a price (if it's lower) from the beginning of the period if your plan has the attractive "lookback" option (the Grant Date). This "lookback" function is appealing since it allows you to purchase shares at the lesser of two prices: the beginning or end of the period. 

Let's take a look at a hypothetical situation.

Example 1: Rising Share Price — Your employer's stock is trading at $10 per share at the start of the offering period, rising to $15 per share by the purchase date. Thanks to the lookback provision, you can buy shares at a discount to the lower of these two values, which is $10 per share. 

Example 2: Falling Share Price — At the start of the offering period, your employer's stock is selling at $20 per share, but by the buy date, it has fallen to $15 per share. The lookback provision isn't in effect here. Therefore you can buy shares at a $15/share discount from the current price.

The lookback provision is a terrific benefit since it either magnifies your gain in a rising share price scenario or allows you to buy shares at a discount to the current market value (and sell quickly to lock in this gain, known as a "Quick Sale") in a falling share price scenario.

Contribution Limits

The IRS sets a limit of $25,000 in pre-discounted contributions to your Employee Stock Purchase Plan (ESPP) per calendar year. With various discounts, here's what your contribution limit can look like:

IRS Limits on ESPP Contributions - Vincere Wealth Management
Source: Vincere Wealth

Companies can limit your contributions to a percentage of your pay or a fixed dollar amount if they want. The average maximum salary contribution to an ESPP is between 10% and 20% of one's pay. It's crucial to remember that your ESPP contributions are calculated on a gross salary basis (before taxes or withholdings are deducted).

Consider the following scenario: You choose to contribute 10% of your salary to your ESPP, your annual salary is $200,000, and you are paid monthly. Your ESPP contributions total $20,000 per year, or $1,666 each month. Assume that your monthly take-home pay is $10,000 after withholdings and deductions for taxes, 401(k) contributions, health insurance, and other expenses.

As a result, this $1,666 monthly payment (10% of gross earnings) represents a higher percentage (16.6%) of your net take-home pay.

Should You Join Your Company's Employee Stock Purchase Plan?

Is it wise to invest in an ESPP?

Would you buy a $100 bill for $50 if you had the opportunity to? We’re sure you’d say yes! The same can be true if you're a part of your company's Employee Stock Purchase Plan. If you can afford it on a monthly cash flow basis, you should take advantage of the opportunity.

As previously stated, the discount is the primary advantage of an ESPP. Shares can be sold quickly (known as a "Quick Sale"), resulting in a minimum 18% pre-tax gain assuming a 15% discount. We always get at least 15% off the market price at the Purchase Date with a lookback period, and occasionally much more if the stock price has climbed since the beginning of the offering period. The payoff profile can be seen in the chart below, which assumes a $10 price at the start of the offering period and a 15% discount.

ESPP Shares Percentage Gain
Source: Vincere Wealth

You have a built in gain with upside potential due to the discount.

Pretty good investment, right?

How Does ESPP Taxes Work?

An ESPP is a relatively simple program that only becomes complicated when taxation is included in. Taxes aren't owed until you sell your shares in an ESPP, but the tax treatment varies based on whether the transaction is "Qualifying" or "Disqualifying."

There are two types of dispositions:

Qualifying: Shares are those held for two years from the grant date and one year from the date of purchase.

Disqualifying: Does not meet the above criteria. Shares must be held for two years from the date of grant and one year from the date of purchase.

A portion of the discounted purchase price is recognized as income when shares are sold under a Qualifying disposal, but the remaining gain (if any) is taxed at lower long-term capital gains rates. That may sound appealing, but it has a significant disadvantage. You must keep the shares for at least another year after the purchase date, and you risk losing money if the price falls. Unless you're trying to accumulate shares of your company's stock actively, the tax advantages of ESPP shares aren't something you should take advantage of.

We usually recommend selling the shares as quickly as possible via a "Quick Sale" to lock in the free money from the discount (which could be lost if the stock price decreases while waiting for the disposition to become Qualified).

As a result, ESPP shares are taxed as follows:

If you qualify, you will be taxed on the discounted purchase price as regular income. Any profit over this threshold is taxed at the lower capital gains rate.

If you are disqualified, the difference between the market value of your shares when you sell them and your (discounted) purchase price is taxed at 100% as ordinary income and is subject to federal, state, and local taxes.

Consider this scenario, which has both qualifying and disqualifying dispositions:

Scenario: Jeff's company provides a six-month ESPP with a one-year lookback period and a 15% discount every six months. The price per share is $40 at the start of the period and rises to $50 on the purchase date. Jeff's contribution is used to buy 250 shares of his employer's stock at a discounted price of $34 per share ($40 x 15% discount = $34 per share).

Before a qualified plan can be implemented, shareholders must approve it, and all plan members have equal rights. An eligible ESPP's offering period cannot exceed three years, and the maximum price discount that can be offered is limited. Non-qualified plans are exempt from many restrictions that apply to qualified plans. Non-qualified plans, on the other hand, do not offer the same tax benefits as qualified plans in terms of after-tax deductions.

Example #1 – Qualifying Disposition (Share price remains level): To get the tax break, Jeff must hold his 250 shares for 2 years. Assuming the price does not drop in that time and his shares are sold for $50/share, the $1,500 discount ($40-$34 = $6 discount/share) is taxed as ordinary income and the remaining $2,500 gain ($50-$40 = $10 gain/share) is taxed as a capital gain.

Example #2: Qualifying Disposition (Share Price Drop): If the stock price falls while Jeff is waiting for the disposition to become qualified, he will miss out on the discount. In this example, when Jeff’s shares are sold at the end of the 2 years, the price has dropped to $30/share. Jeff’s original $1,500 discount ($40-$34 = $6 discount/share) is negated by his $2,500 capital loss ($40-$30 = $10 loss/share). The entire position results in a $1,000 capital loss.

Example #3 – Disqualifying Disposition: Assume Jeff sells his 250 shares for $50 per share immediately after the purchase date (a "Quick Sale"). The full gain of $4,000 ($50-$34 = $16 gain/share) is taxed as ordinary income because there is no favorable tax treatment.

As you can see, if your stock rises dramatically between the start of the offer period and the exercise date, a large portion of the gain will be taxed at capital gains rates; nevertheless, you will be subject to market fluctuations on the stock for another year. (Here's a link to a useful ESPP tax calculator.) Unless you have a specific financial goal in mind, we recommend selling your employer's stock immediately and using the proceeds to either meet an urgent financial goal or reinvest as part of your diversified portfolio. On that point, we'll look at how you may use ESPP shares to help you achieve your financial objectives and as part of your entire financial plan.

Developing an ESPP Strategy to Achieve Your Goals

Because of the lower purchase price, ESPP shares can be used as a turbo-charged savings account to help you achieve your financial goals faster.

Let's have a look at a few options:

1. Supplement your Cash Flow – While initially a drain on monthly cash flow, the program can improve your annual cash flow after your initial enrollment period because shares are purchased at a 5 -15 percent discount. 

*Consider this scenario: You contribute $10k to an ESPP every six months, and you utilize that money to buy (and then sell) approximately $11,760 of stock at a 15% discount (assumes no price appreciation; gains would be more significant if the share price increases). Even after income taxes (assuming a total tax rate of 35 percent), you'll have a $1,055 gain in cash flow every six months!

2. Short-Term Goals – Continuing with the previous example, you can use your Employee Stock Purchase Plan to accelerate your savings for short-term goals. $10,000 saved will get you $11,055 closer to your goal. (An ESPP can be used to help fund the down payment on your first home!)

3. Accelerate Your Savings – Your ESPP gains can be used to increase additional savings in a retirement account (Traditional IRA, Roth IRA), HSA account, or boost your savings in a taxable account, even if you aren't saving for near-term goals. 

4. Transfer ESPP Shares to Brokerage Account Finally, if you want to accumulate shares of your employer's stock at a discount, the ESPP program may be a good option. If you are particularly optimistic about your employer's future (and risk-taking) or are working toward a minimum holding requirement in your business stock, you may wish to do so (required at many companies for senior executives and directors). After you've purchased the shares through the ESPP, you can transfer them to whatever brokerage account you like.

Finally, consider how an ESPP strategy might be incorporated into the rest of your financial plan and investment strategy.

"When should I sell my ESPP shares?" is a common question. To that, we'd say it depends on the following factors:

1. Determine how much company stock you want to hold – As we've already mentioned, keeping company shares might be a risky strategy. You're not only taking on the risk of investing in individual stocks; your pay, bonus, and other equity incentives, such as RSUs, are already linked to your employer's success. The first step is to figure out how much employer stock you can hold. To begin, a percentage of no more than 10% is an appropriate starting point.

2. Automate Your Strategy – Once you've decided how much company stock to hold, automating it is the most straightforward approach to stick to your plan. Whether you choose to hold 0% or 10% of your liquid net worth in your employer's stock, we recommend that once you've hit that threshold, you set your ESPP sale strategy to sell immediately so you don't forget to sell the shares later and mistakenly exceed the threshold you selected.

So, if your employer offers an ESPP, you should jump at the chance to take advantage of it! 

Understanding how the program works and considering how to include ESPP shares into your overall financial strategy can be a powerful tool to help you reach your financial goals faster.

At Vincere Wealth, we work with professionals to help them get the most out of their company benefits, such as ESPPs, RSUs, Deferred Compensation, and the Mega Roth 401(k), as well as provide holistic financial planning and investment management for our clients.

Need help incorporating your ESPP into your financial strategy? Schedule your free 1:1 consultation here

We hope this blog was helpful. Cheers! 

Josh Bennett - Founder of Vincere Wealth Management
Josh Bennett

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