A few years ago I was given the opportunity to participate in my company’s employee stock purchase plan (ESPP). After some research, I discovered these plans can be a huge benefit if you do them right.
Most people who have access to an Employee Stock Purchase Plan should definitely use it, max it out, and flip it immediately. Doing so will almost guarantee an almost 30% annual return on your money.
Are you considering your company’s ESPP? Lucky you! Let’s dig into the details of what an ESPP is, see an example, and discuss the tax implications.
Table of Contents
What are Employee Stock Purchase Plans?
An ESPP is a type of benefit that a company will offer up to employees. They are basically an opportunity for the employee to purchase company stock at a discount price, up to 85% of the price of the stock.;
Companies do this (give you stock at a discount) simply to create an incentive for you to work hard for the company and keep you around for a while.
The way the plan is typically funded is by automatic withholdings from the employee’s paycheck at a percentage of your income (usually 1% to 10%).
The funds are withheld until a certain term is met, typically three, six, or 12 months. At that time, the funds are used to purchase your company stock.
At what price is it purchased?& Typically, the purchase price is the price the stock was at the time you started contributing to the fund (grant date) or the stock price at the time you purchased the shares (whichever is lower), less the 15% discount. You can then sell or hold the stock.
ESPP Terminology
With any investment, you will want to know the terminology that helps you make decisions. Here are the main parts of an ESPP you will want to know before deciding to purchase.
Offering Period
This is the period of time where you will be accumulating payroll deductions. These deductions will then be used to purchase your stock during the purchas period.
Purchase Period
Also known as the exercise date, the purchase period is the time when you employer will purchase company stock on behalf of all employees participating in the plan.
There is no rule to how often an employer will exercise the purchase. In our example it is every six months which is fairly common.
Qualified vs. Nonqualified Plans
ESPPs have two varieties that are determined by how they are treated by the tax code. A nonqualified plan does not receive any special treatment when it comes to taxes.
A qualified plan is covered by section 423 of the IRS tax code which can qualify your earnings for capital gains instead of income tax (we cover this later on). Most plans are qualified plans so all our examples and information going forward will be from that perspective.
My Employee Stock Purchase Plan Example
A few years ago–back when I was employed–my company started touting their Employee Stock Purchase Plan (ESPP.) At the time I was new to the company and had never participated in one of these before. I really didn’t know what to think.
I already had some company stock (via options) from when I was hired. In my opinion, owning those options was enough company stock for me.
You never want to own too much of one stock, right? Definitely not your own company. After all, being that I’m employed here, I’m already heavily invested in them.
15% return? I’ll take it.
Well, a co-worker (who knew I love talking about saving money) started talking to me about this plan and told me she was going to do it. She shared with me the basic concept.
You make automatic contributions (between 1% and 10%) every pay period to a fund, that after six months is used to purchase company shares of stock at a 15% discount. You are then free to do whatever you want to with this stock.
If you sell it that same day (called ESPP “flipping,”) you simply make the 15% discount. Not bad for six months, right? That’s an annualized return of 30%, less taxes. Nice. I’m not going to be getting that anywhere else.
(It’s actually more of a return if you look at it like this article from The Finance Buff details.)
Can we do this?
My thoughts quickly turned to my property tax self-escrow with Capital One 360. Why not use the ESPP in place of the Capital One 360 account (currently earning a small percentage)?
For the record, we have our emergency fund with Capital One 360 as well, so I wouldn’t be pulling ALL our money out of savings, just the property tax portion that I had set up in an extra account (contributing $350/mo.) Check out our full review of Capital One 360 here.
My next step was to do some actual, in-depth research on ESPPs and my company’s plan to be sure this was the right move for my wife and I. You didn’t think I’d just blindly sign-up based on a few co-worker’s suggestions, did you?
After some research, I was ready to pull the trigger. I started the ESPP and here’s how the numbers broke down:
- Term: Six Months
- Discount: 15%
- Contribution: 10% of Salary (After-Tax)
- Annual Income: $50,000
- Stock Price at Grant Date: $30/share
- Stock Price at Purchase Date: $35/share
- Strategy: Flip or Quick Sale
ESPP Example
The Purchase
$25,000 (six mo. of income) x .10 (contribution) = $2,500
$30 (“lowest of” share price) x .85 (1 – discount) = $25.50
$2,500 / $25.50 = 98.04 shares of stock
The Sale
98.04 x $35* = $3,431.40
$3,431.40 – $2,500 = $931.40 GAIN (64% Annual Yield)
*Assumes the stock price doesn’t change in the short time it takes to sell the stock.
My first ESPP flip was a huge success. After this, I continued to use this company benefit for as long as it was offered.
When to Sell Your Employee Stock Purchase Plan Shares
It’s up to you to decide when to sell your share. I like the idea of selling your shares as soon as you can (aka “flip” them.) The removes the risk of holding on to too much company stock and it also virtually locks in the 15% gain.
Some have questioned flipping as unethical. I challenged that idea initially and was validated by my own company. The brokerage firm that handles our ESPP process allows you to sign up for ESPP “Quicksale.”
The Quicksale is what it sounds like: by activating Quicksale, the broker immediately sold my shares of stock in the company upon purchase. They are essentially doing the flip for me.
How is an ESPP Taxed?
Your contribution to the ESPP is typically withheld from your paycheck AFTER-tax. Therefore, there are no tax effects as a result of contributing to the plan. Once the period ends and the shares are purchased, you simply own the stock…no tax effect there either.
It’s when you sell the stock that you are required to pay taxes. If, when you sell the stock, it’s been less than a year since you purchased the stock, it’s called a “disqualifying disposition” and your employer will simply list the gain of the sale on your Form W-2 as ordinary income.
If it’s been more than a year, a portion of the gains would be considered long-term capital gains. See Turbo Tax’s explanation on this.
Related: How To Put Together A Winning Taxable Investment Portfolio
Employee Stock Purchase Plan Tax Calculator
Looking for an ESPP tax calculator to help determine what your tax result will be. My friend Adam over at Minafi has you covered. He’s got an attractive little calculator to help you determine what your tax implications will be.
Can You Lose Money with an ESPP?
If you hold onto the stock and it goes down in value, then yes you can lose money with an ESPP.
However, if you use the strategy of immediately selling the stock, you lock in your profit directly after making the stock purchase.
If you believe in your employer and their long term profitability, you can hold onto some of the stock with the expectation of an increase in the price. This is a riskier move but can pay off if your company stock price does go up.
Are ESPPs Good Investments?
Unless your company is a sinking ship I absolutely believe the ESPP is worth it. It’s just about as close to the company 401k match as you can get. And the benefits are realized so much quicker. It’s a no-brainer to use the ESPP if you have one.
Here’s more on the value of the ESPP from Beat the Bush:
Make the Most of Your Employee Stock Purchase Plan
Everyone’s plan varies, but you can achieve the most (in terms of security and return) from a “typical” ESPP by doing the following:
- Contribute the Maximum: The more you contribute to the ESPP, the bigger your return will be if you plan on flipping it. Do your best to contribute at the maximum level of the plan. The return is too big to pass up.
- Flip the ESPP: Once you reach the end of the term and the shares are purchased, immediately sell your shares of stock so that your risk is limited. If you can manage it, short sell the stock just prior to the end of the term and reduce your risk even further.
- Have a Goal for the Funds After the Sale: Just so that you don’t thoughtlessly blow all of your ESPP savings and earnings, have a nice plan for using it after the sale. Good luck.
Looking for a place to stash those ESPP earnings? Check out our list of the best savings accounts.
Have you ever participated in your Employee Stock Purchase Plan? If so, what were the results?
