- An Employee Stock Purchase Plan (ESPP) is a program offered by many public companies that allows employees to purchase shares of the company’s stock, often at discounts of up to 15% from the fair market value
- ESPPs are an elective workplace benefit, which means employees must enroll during an open enrollment period to participate
- ESPPs purchases are generally limited to a maximum of $25k per year but some employers have a lower limit
- Once you contribute, you can’t get your money out until you purchase, and sell, your shares. If there is a required holding period, it could be months before you can touch your money
- It’s important to understand how your employee stock purchases would fit into your overall financial strategy before enrolling
Picture this: It’s open enrollment time or you just started a new job at a company and you’re scrolling through endless pages of offerings, trying to choose healthcare, vision, and dental options and looking at your company’s 401(k) plan.
You notice something called employee stock purchase plan (ESPP) and wonder if it’s worth checking out or if you should just keep scrolling.
You’re not alone in your indecision. Almost half of the large companies in the S&P 500 offer ESPPs to their employees, yet few take advantage of this benefit that allows them to purchase company stock at up to a 15% discount.
What is an employee stock purchase plan?
An Employee Stock Purchase Plan is a program offered by many public companies that allows employees to purchase shares of the company’s stock, often at discounts of up to 15% from the fair market value of the stock.
For example, employees would have an opportunity to buy stock that’s worth $10 a share for only $8.50. The programs are part of the compensation and benefits package offered to employees and participation is optional.
ESPPs can be qualified or unqualified, which involve two very different tax treatments, so it’s important to know which type your employer offers.
How do employee stock purchase plans work?
ESPPs are an elective benefit. This means employees must enroll in the plan to participate. As with many other workplace benefits, there are open enrollment periods, also known as offering periods. Most employers have open enrollment every six months.
The Internal Revenue Service allows employees to contribute up to a maximum of $25,000 per year towards the purchase of company stock, although some employers may have a lower limit.
Once enrolled, contributions are withheld from your paycheck (payroll deductions), just as they would for many other benefits.
The difference is that ESPP contributions are after-tax. The deducted funds aren’t used to purchase shares immediately. Rather, they are held by the employer until a specified purchase date. Think of this as your employer aggregating your funds in an account designed for safekeeping until the purchase date arrives.
On the purchase date, your employer uses your accumulated funds to purchase shares of your company’s stock, typically at a discount.
That discount can be as high as 15%, which is the maximum allowed by the IRS. Some companies offer a matching contribution to the plan in lieu of a discount.
One great feature: the share price and discount are calculated twice; once when the enrollment period begins and again when the employee actually buys shares. The employee pays whichever amount is less. Here are two examples.
- You enroll in a plan when the share price is $10. Six months later the stock is worth $12 per share. You are able to buy shares at the $10 purchase price minus a 15% discount, so your price per share is $8.50. This is called a look-back provision that is unique to ESPPs.
- You enroll in a plan when the share price is $10. Six months later the stock is worth $8 per share. You are able to buy a share at a 15% discount to the $8 share price, which is $6.80.
As with other investments, you can choose to either hold the shares as part of your investment strategy or sell them immediately and use the cash for other goals. If you sell the shares, you will owe taxes on any gains.
Some plans may require you to hold the shares for a set amount of time before you sell them. Any holding period is set by the company, so it’s important to review the plan's documents to confirm discounts, employer matches, contribution limits, and holding periods.
How are ESPPs taxed?
There are two types of ESPP plans, qualified and non-qualified. The main difference between the two is when the employee must pay taxes.
- For qualified plans, there is no tax due when shares are purchased. Employees will be taxed when shares are sold.
- If your company’s plan is a non-qualified plan, you will owe taxes when you purchase your shares, whether you sell them or keep them.
For both plans, you’ll pay different taxes depending upon when you sell your shares. For ESPPs, sales are called dispositions. These are the differences.
What is an ESPP qualifying disposition?
- Shares sold at least two years after the offering period started and one year from the date you purchased them.
- The discount your employer gave you on the share price is taxed at your ordinary income tax rate.
- Growth is taxed as a long-term capital gains tax.
What is an ESPP disqualifying disposition?
- Shares sold less than two years from the offer date or less than one year from purchase, or both.
- The discount your employer gave on the share price is taxed at your ordinary income tax rate.
- Growth is taxed as long-term or short-term capital gains, depending upon how long you’ve owned the shares.
Should I participate in an employee stock purchase plan?
Before enrolling in an ESPP, it’s important to understand how your employer’s stock fits into your overall financial strategy so you don’t shortchange other goals you may have, such as contributing to your 401(k) or saving for a home purchase.
That being said, if your company offers an ESPP, you should consider enrolling in it. Employee stock purchase plans that offer either a discount or an employer match give you the opportunity to buy stock for less than market price. Keep in mind you have to meet the eligibility requirements for the plan and employers can exclude certain highly compensated employees, so check your plan documents.
Here’s what to consider before stashing your money away in an ESPP:
- How much can you contribute and how much should you contribute? Plan limits vary, but the maximum allowable contribution is $25,000 per year. The number that’s right for you depends on the rest of your financial plan and savings and investing goals.
- Are you prepared to have your money tied up during the offering period? Once you contribute, you can’t get your money out until you purchase, and sell, your shares. If there is a required holding period, it could be months before you can touch your money. Make sure you plan ahead for the lack of liquidity and the change to your cash flow.
- What is your strategy for the plan? Do you plan to sell the shares immediately and use the proceeds, hold the shares longer-term to get preferential tax treatment, or hold them indefinitely as part of your overall investment strategy? Each strategy requires a different approach to planning and risk management.
ESPPs can offer an excellent opportunity for employees, but it’s important to understand IRS regulations, your employer’s program, and how ESPPs fit in with your overall financial strategy.
To learn how a CFP® Professional at Facet can help you plan for an employee stock purchase plan and maximize its value as part of your overall strategy, get in touch today.