What You Need to Know About Employee Stock Purchase Plans

Employee stock purchase plans (ESPPs) are one of the less common, and less well-known employee benefits offered by employers.

It's one way that you can invest.

Now:

That doesn't necessarily mean you should participate in the plan if your employer offers it.

But, at the very least, you should investigate the plan to see if you'd be interested in this perk.

Some companies offer generous benefits as part of the plan.

Unlike a 401(k) plan or health insurance plan, participating in an employee stock purchase plan shouldn’t be an automatic decision.

Find out how they work and whether you should take advantage of this perk.

What Are Employee Stock Purchase Plans?

Generally, these plans allow employees to invest in stock of their own company.

ESPPs are not to be confused with employee stock ownership plans (ESOPs).

The plans are company-sponsored and enable participating employees to buy shares in the company at a reduced price.

They’re usually not available for employees who own more than 5% of the company’s common stock.

But even among employees who are eligible to participate, there's generally a waiting period. That typically is one year from the beginning of employment.

Optional

Employee stock purchase plans are an employee benefit, which means that while the employee has the option to participate, he or she is not required to do so.

Much like choosing the parameters for participation in a 401(k) plan, the employee can choose the amount to be deducted from their pay to participate in the plan.

The IRS limits contributions to not more than $25,000 per year.

Employees are able to purchase company stock under the plan at a discount.

This provides an incentive for employees to participate in the plan, but also work toward successfully meeting company profit goals.

After all, the more profitable the company is, the more valuable its stock will become.

That will provide employees with a higher return when they finally sell their shares.

How Do Employee Stock Purchase Plans Work?

As noted above, the IRS limits contributions to an employee stock purchase plan to not more than $25,000.

The shares purchased in the plan are fully vested as soon as the purchase takes place.

Contributions

When enrolling in the program, you will have the option to contribute either a fixed dollar amount of each payroll to the plan, or you can use a fixed percentage.

The company may limit the percentage of your contribution, but this varies by employer. There may also be limits on the number of shares you're allowed to purchase.

Holding period

There’s usually a holding period, during which after-tax contributions can be made to the plan.

The plan may provide for funds to build up in your plan, then used to purchase stock periodically.

For example, you may contribute funds from payroll, which are then used to purchase stock at the end of the quarter, or some other time frame.

Reduced stock price

The main attraction of an ESPP for employees:

The stock is generally purchased at discount.

The discount can be as high as 15%, but employers can set it at whatever level they choose. They can even adjust the discount, either higher or lower, going forward.

In an interesting variation, an employer can offer a look-back provision.

For example, they may allow you to purchase the stock at the lower of the share price at either the beginning of the purchase period or the end.

That would provide an additional price benefit to the employee.

Different Kinds of Employee Stock Purchase Plans

There are two basic types of employee stock purchase plans, qualified plans and non-qualified plans.

Qualified plans

This type of plan enables employees to purchase company stock at a discount.

The discount does not have to be recognized for tax purposes until the shares are sold. At least one year must pass after purchase of the stock before it can be sold.

But that results in a more favorable long-term capital gains tax treatment.

Under a qualified plan, there are two holding period requirements that need to be met:

  1. Disposition of shares must occur more than two years after the grant date, and also
  2. At least one year after the purchase date.
  3. The second requirement will ensure that the sale qualifies as a long-term capital gain, and will, therefore, be subject to lower long-term capital gains tax rates, which may even result in no tax on the gain for lower-income taxpayers.

Non-qualified plans

Under this type of plan, employees are also able to purchase company stock, but it creates an immediate tax liability.

Taxes must be paid on the discount on the stock at the time it is purchased.

If you subsequently sell the stock at an amount higher than the full purchase price of the stock, it will be considered a capital gain in the year in which the stock was sold.

If the stock is sold within one year of purchase, it will be considered a short-term capital gain, and also taxable at ordinary income tax rates.

But if the sale occurs more than one year after purchase, it will be considered a long-term capital gain, and taxed at more favorable rates.

Example

Let's say you earn $60,000 per year, and you choose to contribute 10% of your salary to your company’s employee stock purchase plan. That will come to $6,000 per year.

You accumulate funds the plan, at a rate of $1,500 per quarter, when you're allowed to purchase company stock.

On March 31st, the company’s stock is trading at $100 per share. Under the terms of the plan, you're eligible to purchase the stock at a 15% discount.

That means you will be able to buy stock for $85 per share. The plan is a qualifying plan, so there will be no tax liability created by the purchase of the stock at a discount.

With $1,500 available, you're able to purchase 17.65 shares of stock ($1,500 divided by $85 per share).

Assuming the stock price remains at $100 per share throughout the year, you will be able to purchase 70.6 shares of company stock for the full year.

Selling stock purchased

Just over one year after the purchase of the 70.6 shares of stock for $6,000, you sell the stock at $150 per share. The total sale price is $10,590, producing a net gain of $4,590.

That gain will be taxed in two ways:

  1. The portion of the sale representing the discount will be taxed as ordinary income.
  2. The gain over the full purchase price will be taxable as a long-term capital gain.

In this example, the actual purchase price of the stock is $7,060 (70.6 shares X $100). But since you only paid $6,000 for the stock, $1,060 is taxable as ordinary income.

The gain on the sale of the stock over the actual purchase price is $3,530.

Since it represents a long-term capital gain, it will be taxed at long-term capital gains tax rates, which are lower than your ordinary income tax rate.

For example, if your ordinary income tax rate is 22% – which will apply to the discount on the stock purchase.

But your long-term capital gains rate will be limited to 15%, and that’s the rate you’ll pay on the amount that represents the gain over the full purchase price.

Strategies

If you're going to participate in an ESPP your contributions should be limited to money you can afford to lose.

You should also plan to sell shares accumulated in your plan on a regular basis.

For example, stock purchased in 2019 should be sold in 2020, or shortly thereafter.

The basic idea is:

Avoid accumulating too large a position in company stock. You’ll also want to be sure you're able to sell at a profit. That's when you actually realize the full benefit of participating in an ESPP.

Under ideal circumstances, the value of your company stock will rise steadily, giving you an opportunity to sell a portion of your holdings each year.

In that way, you will both cash in on the benefits of the plan on an yearly basis, as well as minimize your annual tax liability.

Costs

There are typically no fees either to participate in an ESPP, or to purchase stock under the plan.

However, there may be trading fees involved upon the sale of the stock, depending upon how that's handled within the plan.

Pros & Cons

Pros:

  • Stock is purchased at a discount, providing an immediate gain.
  • Under qualified plan, no taxes are due until stock is sold.
  • Stocks held for more than one year are subject to lower long-term capital gains tax rates.
  • Stock purchased under an ESPP are immediately vested.
  • There are generally no fees to purchase stock.

Cons:

  • There is no tax break for contributions to an ESPP
  • Under non-qualified plans, tax will be due on the discount, before the stock is even sold.
  • Contributions to an ESPP may force you to reduce contributions to other plans, like your 401(k).
  • There’s no real benefit unless you can sell the stock at a gain.
  • Your money will be tied up for one year or longer.

Should You Invest through an ESPP?

As mentioned at the beginning of this article, you should participate if the plan offers generous benefits.

That means it's a qualified plan, that offers a discount of 15% or something close to it.

But in doing so, also consider the following:

  • Contributions to the ESPP should not seriously reduce contributions to your 401(k) plan. That plan is both tax-deferred, and increases long term wealth, while the ESPP tends to be a shorter term play.
  • Limit your participation in an ESPP if you regularly invest in your company stock through your 401(k) plan, Otherwise you might be overweight in company stock.
  • You may want to avoid a non-qualified ESPP, since it will create a tax liability before you even sell your stock.

But there's an even bigger factor than all of the above, and that's the future prospects for your company's stock.

You have to be as objective as possible here. If analysis from external sources indicates the company is on a strong growth trajectory, the ESPP can make abundant sense.

But if the company stock is expected to be stagnant, or even decline in the future, an ESPP can quickly turn into a losing proposition.

Final Thoughts

Carefully analyze whether or not you will participate in your company’s ESPP.

The success or failure of the plan really depends on the future prospects for the company’s stock.

If you have any doubts about it, you'll be better off contributing any extra funds to your 401(k) plan, where it can be invested in better-performing assets.

But if you have a lot of confidence in your company and its future, making a small allocation to an ESPP can provide a steady stream of investment profits going forward.

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