• Nate Baim, MBA, CFP®

Master Your Employee Stock Purchase Plan


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Warren Buffet once said, "Never invest in a business you cannot understand." In other words, buy what you know. Investing in enterprises and industries you possess deep knowledge can aid you as an investor. And thus, it is not uncommon for employees of companies that offer an Employee Stock Purchase Plan to participate. Investing in your company can be a substantial portion of your equity allocation. This can be especially true if the program offers an excellent discount. It is not uncommon for Employee Stock Purchase Plans (ESPPs) to allow employees to buy shares of company stock at a 5%-15% discount with after-tax dollars. Some plans can have other advantages, such as a lookback, where employees get a better deal.


With such generous provisions, ESPPs can provide excellent opportunities for investors! But should you take advantage of your ESPP? And if you do participate, how should you manage your holdings? Before adding your company stock to your investment plan, you should carefully review your objectives. We break down what you need to know.


Understanding the ESPP Timeline


Enrollment/Grant Date

An ESPP is a benefit extended at some publicly traded companies that grant employees the ability to buy their employer's stock at a discount. Employees can usually enroll twice a year in the plan and choose the percentage of salary to contribute. Each program is different, but the tax code limits employee contribution to a maximum of 15% of annual salary or $25,000.


Once enrolled in the plan, the company will set up your ESPP account, often with a brokerage company. Your employer will transfer the amount outlined in your enrollment form from your paycheck into the ESPP account to buy shares in the company. Programs often enable employees to sign up for a six or 12-month offering period. The official start of ESPP participation is at the beginning of the offering period for most plans. The beginning date (also called the grant date) is important for tax purposes and with helping to set the price for lookback benefits.


Offering Period/Purchase Date

Payroll deductions are set aside during the offering period, and the plan begins accumulating funds. The offering period typically lasts for six months or a year. The program then purchases shares with the funds collected in the account at the end of the offering period. Companies without a lookback period will buy stock for you below-market price when the offering period ends (usually at a 15% discount). Section 423 of the tax code caps the employee's discount on stock purchases to 15% below the market price. Most plans operate under Section 423.


Some ESPPs include an extra benefit called the "lookback period." With this feature, the employee can still obtain a 15% discount. However, the lookback feature applies the discount to the lower of two price points. The two price points considered are the first day you began to set aside money (the option grant date) or the stock price on the day of the purchase.


Here's how the lookback works, using as an example a company that has a 15% discount and a six-month lookback. On the employee's offering date of June 1, the stock was trading at $15 a share. By the purchase date of December 1, it had climbed to $20 per share. The lookback means you can purchase a stock trading at $20 for $12.75 (a 15% discount on the June 1 price of $15).


Employee Stock Purchase Plane Timeline

The purchase date occurs at the end of the payroll deduction period (also called the offering period). The plan purchases shares on this date. Some ESPPs have offering periods where several purchase dates may occur.


Transferring the Stock

The employer is responsible for safeguarding employee funds accumulating in the plan. The company then buys shares of the company's stock at predetermined dates. The mechanics of this process is that the brokerage administering the ESPP plan makes the actual equity purchases. The brokerage then transfers ownership of the stocks to the employees enrolled in the plan. Employees receive a refund for any cash leftover from the purchases.


The brokerage administering the ESPP will also send a trade confirmation to each employee. Employees do not receive a tax bill when the shares are purchased on their behalf and transferred to them. But there are tax obligations when you sell the shares.


Understand the Tax Consequences


Most ESPPs are "qualified" plans. Qualified ESPPs should not be confused with qualified retirement plans; qualified retirement plans adhere to an entirely different set of rules. Other types of ESPPs are non-qualified or direct purchase plans.


Tax-qualified or qualified ESPPs adhere to IRS Section 423. Under Section 423, the employee may obtain favorable tax treatment for the purchase discount if they own the shares long enough. To earn this tax-favored status, the employee must wait more than two years from the grant date and at least one year from purchase.


Let's illustrate a qualifying disposition of shares purchased under a qualified ESPP. Suppose the employee holds the stock for the required time. In that case, the discount earned is taxed as ordinary income, and the remainder of the profit is taxed at the lower long-term capital gains tax rate.


Now, let's illustrate a disqualifying disposition of shares purchased under a qualified ESPP. Suppose you sell the shares immediately after the units are purchased. You will pay ordinary income tax on the difference you paid (including the discount) and the sale price for each share (the IRS considers the discount to be a salary).


Non-qualified plans may offer discounts higher than 15% on each share and provide matching shares. However, they lack tax advantages offered under qualified plans. With non-qualified plans, employees receive a tax bill when the shares are purchased on their behalf (you pay ordinary income taxes on the discount you received).


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ESPP Planning and Management


Just as with any individual equity, the value of the stock in your ESPP can fall for various reasons, including poor company performance, a recession, or other economic headwinds. A 15% drop in the value of your shares can eliminate the discount earned by participating in the plan. Losing money is even more critical when your income and a substantial portion of your investment portfolio rely on your company's performance.


Keeping equity risk in mind is essential. In addition to ESPP, employees may also receive stock options or restricted stock units as part of their total compensation. Employees may own a substantial percentage of company stock relative to their total portfolio. For this reason, investor employees should carefully consider the tax benefits of holding the equity for extended periods versus the benefits of managing risk in their total portfolio. So here are the key things you should consider surrounding your ESPP:

  • How much stock are you willing (or have) to hold as a percent of your total portfolio?

  • How will you manage concentration risk if you plan to hold a large amount of company stock in your portfolio?

  • What goals will you be working toward when participating in an ESPP?


Here are the common tactics folks may use when optimizing their ESPP:

  • Savings for Mid & Long-Term Goals - ESPP can help you automate savings for mid and long-term goals. It is not uncommon for people to use ESPP to fund education or a new home purchase. The automated payroll deductions from your paycheck help you avoid forgetting to save money manually. However, ESPP doesn't automate how much company stock you should accumulate. Suppose you are using ESPP as a mechanism to attain valued goals. In that case, I encourage folks to carefully consider how much employer stock they hold and avoid concentration risk. But, the discount used over time can help you attain your goals sooner.

  • Augment Current Cashflow - Sure, you have to set aside some income during the offering period, but the discount earned can boost cash flow in the future. The discount provided by the ESPP can offer increased cash flow for a household that can use the additional money for discretionary spending.

  • Accumulate Shares - This may make sense for someone who needs to attain enough shares to meet a minimum holding requirement (a common requirement of executives). It may also make sense to accumulate shares for an optimistic individual who can afford to take the risk. Again, the optimistic individual should carefully consider holding too much employer stock if their income and portfolio heavily rely on stock performance.


Each person should carefully consider their situation before taking any action. However, I often recommend employees who don't have minimum holding requirements take advantage of the discount. And I often encourage them to quickly sell any ESPP if a significant portion of their income or portfolio relies on the performance of their employer. Then use the proceeds from the ESPP to fund their goals by investing in a diversified portfolio.


Some ESPPs offer a Quick-Sale Program where the selling becomes automatic, potentially reducing transaction costs. Quick selling is a tactic where the stock is sold immediately after purchase. This reduces the likelihood of any stock appreciation being realized. But quick selling helps manage the risk of loss. And although the tax benefit can be nice, managing risk tends to trump any potential tax savings. This philosophy goes back to "don't let the tax tail wag the dog."


The Takeaway


ESPPs are a unique benefit that allows companies to offer employee stock ownership. ESPP enables employees to invest in company stock at a significant discount. Still, it's essential to monitor your account to prevent your holdings from becoming too large a percentage of your total investment portfolio.


Are you trying to figure out what to do with your ESPP? At Pursuit Planning and Investments, LLC, I help you think through your options. I ultimately help you make the best decisions for yourself, your family, and your money. Feel free to place a commitment-free 30-minute meeting on my calendar. In that meeting, we can discuss your ESPP and begin best optimizing your financial plan.





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