The other day I was talking to one of my coworkers about our companies Employee Stock Purchase Plan (ESPP). I was surprised to hear he had never heard of the plan, especially given how advantageous a benefit it is to the employee. Todays post will explore the Employee Stock Purchase Plan. I will also touch on why you should maximize this benefit almost regardless of your savings rate.
What is an Employee Stock Purchase Plan (ESPP)?
A qualified Employee Stock Purchase Plan is a company executed plan which seeks to provide shares of the company to an employee at a discounted price. This plan is established by IRS section 423. There are two types of Employee Stock Purchase Plans: Qualified and Non Qualified. If the plan is a qualified plan then it is approved by shareholders, follows certain rules, and provides tax incentives. Non Qualified plans usually are run via the same rules except for the tax benefits, so I will not belabor them further.
Funding ESPP
Like a 401K to fund an ESPP account you elect to put aside a certain percentage of your income each paycheck, in this case after tax. This amount accrues without interest over the course of what is defined as an offering period. The offering period goes from a start date, or offering date, to the date of purchase. At that time a new period begins and the accrued funds are used to purchase your company’s stock at a discount.
Employee Stock Purchase Plan Discounts
Just how discounted are Employee Stock Purchase Plans? By law qualified plans can be discounted up to 15% lower then market price. But what is considered Market Price also depends on the plan. Some ESPP have look back features that considers the lower of the price on the purchase date or the offering date, the period start date, as the basis for the reduction. In theory if your plan provides this feature and your stock has appreciated significantly over the period your discount may significantly exceed 15%. My plan unfortunately did away with the look back functionality. Still a 15% discount is nothing to sneeze at.
Tax Benefits of ESPP
In addition to the discount a qualified Employee Stock Purchase Plan provides potential tax benefits. The first benefit is that all taxes on the discounts are delayed until the year you sell the stock. The actual taxation varies by the length of time you hold the stock. Regardless of your holding period the discounted funds are taxed as ordinary income. The difference is in how much is considered the discount. If you hold the stock for one year from purchase and two years from offering then favorable tax treatment kicks in. The discount percent is than calculated as the discount percent applied to the applicable offering price (either via look back or value on execution date) or essentially 15%. If you do not fulfill the holding than ordinary income is applied to the market price on the date of purchase minus the purchase price on the given date.
All other funds are reported as long term capital gains. Since capital gains rates are typically 15% and ordinary income are typically your existing tax bracket there can be a significant difference here for higher income professionals.
| Favorable Tax Treatment | Normal Tax Treatment | |
| Purchase Price | $4.25 | $4.25 |
| Market Price at purchase | $11.50 | $11.50 |
| Market Price per Lookback | $5 | $5 |
| ordinary income taxrate | $5-$4.25=$0.75 | $11.50-$4.25=$7.25 |
| Capital Gains if sold at market price at purchase | $11.50-$5=$6.50 | 0 |
| Hypothetical 25% tax bracket difference | $0.75*25%+6.50*15%=$1.16 | $7.25*25%=$1.81 |
Eligibility for ESPP
You are eligible to contribute to an Employee Stock Purchase Plan if you do not own more than 5% of the company. Sometimes companies also have requirements for years of service. Otherwise any employee at a company that offers ESPP can participate. Generally your limited to contributing up to a maximum of $25K per year.
Strategies for Employing Employee Stock Purchase Plan
The reality is holding your company’s stock for a decent length of time is dangerous. It is one of the most discouraged investments you can make. If your company falls on hard times you could be hit twice. Once via job loss and the second via assets. Add to that the need for diversification and it is not recommended to buy company stock under normal circumstances. The same arguments can be used for not holding Employee Stock Purchase Plan to the favorable tax treatment term. However, most plans allow you to sell the proceeds of any plan within a few days of purchase.
There are a few companies that require vesting exceptions, in which case I would think twice about investing. But otherwise your exposure to the vagaries of your company’s stock volatility is likely a day or two in exchange for a 15% discount. I.E it is highly likely you will come out ahead by participating in an Employee Stock Purchase Plan if you sell immediately upon purchase. We have averaged greater than 15% return in our periods of participation to date. I always recommend selling the stock immediately given the above.
My Extra Sales Hoops
To give you an idea of how serious I am about selling at posting, note I am considered an insider trader. As such I have certain windows of time where I cannot sell company stock normally. This time period covers the period of purchase of my employee stock purchase plan. So, to ensure I do not have to hold this stock the 3 weeks until window open I put in place a 10b5-1 Trading plan.
A 10b5-1 allows insiders to sell a predefined number of shares on a schedule outside their selling window. To do so they must set up the sale sufficiently ahead of time to prove they are not doing so based on insider knowledge. In my case I have a plan setup to sell my Employee Stock Purchase Plan on the day of vesting. My brokerage will thus sell it automatically for me on the purchase date. No action is required from my side.
Funding ESPP, No excuses
I’ve spoken before about using the fungibility of money to maximize employee benefits. You can use float from savings to live off of while funding the initial round of Employee Stock Purchase Plan from a reduced paycheck. After the initial round you can live off funds from selling prior period holdings. As such as long as you have some savings as seed money there is no reason you cannot capture the 15% guaranteed return using an Employee Stock Purchase Plan. Your savings rate should not be a factor in determining your participation.
Do you invest in an Employee Stock Purchase Plan? Do you maintain the statutory holding schedule or do you sell at vesting?
I do invest in my company’s ESPP and have for about 11 years. We get all of the good benefits that you spoke of with the lookback pricing, 15% off market, etc. I sold a couple of them during the early years as my wife and I were going to use them to pay property taxes. Then I ended up making enough that we didn’t need to do that anymore. Between those and the RSU grants that I’ve gotten in the past, I own roughly 7500 shares that brings me around 8k a year in dividends.
That’s a lot of company based risk. Hope you are diversified well with the rest of your portfolio so it doesn’t matter.
Great post. I’m always surprised when employees don’t know about the benefits and plans that their employer offers. It pays to check them all out, whether it’s a 401(k) or ESPP, or something as simple as a discount on your phone plan. If effect, these are part of your compensation and you should take advantage of each one that makes sense for your situation.
It’s free money you’d otherwise leave on the table.
Was just listening to the Choose FI podcast from a while back, and they also mentioned this. Good chance to get a 10% – 15% bump on your returns, even if the company stock doesn’t move.
Another opportunity that too few people take advantage of.
Mr. 39 Months
Hi Mr. 39 Months,
Very true. People just never take the time to think about these possibilities.
I participate in my company’s plan. We get a 15% discount with look back. I used to keep the stock initially but after a couple of years shifted to automatic sale after the purchase. We used to be able to buy stock with up to 10% of our salary, but now sadly it’s been reduced. Still a great benefit.
I’m limited to 10 percent. It’s an easily overlooked benefit.
My wife gets 15% discount as well. However, I noticed a weird thing with W-2. If I sell 2 years before the grant date, the income from the espp sale ends up in W-2 box 1. If I sell 2 years after the grant date, it doesn’t. Did you guys experience the same thing?
I sell immediately. That being said I’ve heard some employers forget to provide the discount amount in the w-2. In that case you would need to add it into your w2. I’d recommend checking with your employer. Mine does report it.