You may have an Employee Stock Purchase Plan (ESPP) at work. Is it a solid investment? How is it taxed? Should I enroll in the plan? These are questions you are probably asking.
In this article, I’ll explain the basics of Employee Stock Purchase Plans and share a bit of strategy with you as well.
Let’s get started.
Full disclosure: I’m not a CPA, attorney, or licensed professional on the subject. Any information that I give you is my opinion based on my research. Consult other contacts that you have in those fields to get their professional advice as well. Ok, now we can get started.
What is an Employee Stock Purchase Plan (ESPP)?
An ESPP is an employer benefit that some publicly traded companies offer that allows employees to invest in the company by purchasing shares of the company at a discount.
Typically, programs follow a period of 12 months that they allow investment.
Employees that choose to be a part can have a percentage of their income pulled aside by the company in order to invest, up to $25,000 each year.
That money is used by the company to buy shares of the company stock at a below-market price, typically at approximately a 15% discount. Sometimes employers will allow a benefit of ‘looking back’ where employees can make purchases at a later date even if they missed a window. Check with your employer for this.
How is an ESPP taxed?
Is the investment made pre-tax or post-tax? You need to understand how it will be taxed before you go all-in on your company’s Employee Stock Purchase Plan.
This investment is made with post-tax dollars. Therefore, you have already paid taxes on the funds used to purchase shares. You will only pay taxes on the gains you make during the period you hold the stock when you decide to sell.
The type of tax you will pay when you sell also depends on how long you hold the shares. If you sell immediately after purchasing, you will pay income tax on the gain you just made. If you hold the stock for at least a year (and more than two years after the offering period began). Of course, owning a stock long-term has pros and cons as you can’t control the future value.
Do ESPPs make wise investments?
Of course. ESPP’s can be great investments. If you purchase a stock that increases in value, buying that stock at a discount (approximately 15%) is an incredible deal.
An ESPP plan with a 15% discount provides a 17.6% return on investment.
Let me give an example.
Say a stock trades at $100 per share. An employee acts on their ESPP program with a 15% discount and buys shares for $85 each.
Right away, they can sell shares for $100 each.
This sale provides an instant profit of $15 per share on an investment of $85 per share.
$15 / $85 = 17.6%
If you make the maximum $25,000/year contribution to your ESPP plan, you gain thousands of dollars of ‘free money’ from your employer each year. Over 30 years, it’s more than $130,000.
But of course, there’s a risk. There’s always a risk.
Can I lose money on an ESPP?
As you probably already know, the stock market can go up and it can go down and an employee stock purchase plan is no different. In general, when investing, the greater the return potential, the greater your potential risk is. Does this mean you should stay away from the investment?
Of course not.
Everything in life is a risk.
You have an advantage over most independent investors out there.
Because you have intimate knowledge of the company that you work for.
You can feel the company culture.
The way that management treats people and the way that teams are grown.
Are new products being developed?
Maybe you see expansion or growth opportunities?
You can use this information to make a gut decision on where you think the stock price will head in the future.
And it will be an educated gut decision.
How much should I invest?
Investing in your ESPP needs to be a part of your overall personal finance strategy. So this answer will depend on some of your personal goals and how diversified you want your financial portfolio to look. If you are good at laying out your financial strategy, then go with what works. If personal finance stresses you out, you will need to get with a professional to help you decide on an appropriate mix of investments.
I’ll leave you to determine your risk factor and how much you want to invest. If your company has a 401k matching program, I would personally max that out first. A 401k match is free money from your company with no risk of how the company’s stock performs.
What about stock options?
Top employees at companies are often given stock options as a part of their pay. They already have the opportunity to buy in at a specific strike price. Participating in the ESPP may actually be risky and something that they don’t want to take part in.
For employees that have stock options, there is a strategy that they can use with their employee stock purchase program. They can purchase at the 15% discount and sell the same amount of company stock at the same time to limit risk. In this case, the gains are immediately earned. You can then roll the profits into tax advantage accounts as a way of long term savings. This way, the company plan helps provide for your long term savings rather than your paycheck income.
The goal was to provide you with an overview of employee stock purchase plans and give you a few ideas around them. Take a bit of time and develop your personal finance strategy around your company’s program. Personal finance is important and you are responsible for making these decisions. Nobody is going to do it for you.
You are in charge.
Go get after it.
Disclosure: this article might contain links to the resources discussed.