If you’re anything like my husband (smart, tech savvy, but jaded about the financial industry and utterly uninterested in the nuts and bolts of personal finance), Employee Stock Purchase Plans (ESPPs) might strike you as unnecessarily complicated and surely they must be trying to trick you, right?

As it turns out, ESPPs are basically Free Money (well, there’s some risk, but it’s really low). As long as you have a plan and the discipline to stick with it. And there’s the rub, eh? Most of financial success boils down to exactly that.

This article is about qualified Employee Stock Purchase Plans (as opposed to non-qualified). The qualified kind is most likely what you’ll receive as an employee of a tech company.

[Note: A lot of this material comes from my guide to “Optimizing Your Stock Compensation,” which covers ESPPs and four other kinds of stock compensation: incentive and non-qualified stock options, 401(k) match with company stock, and restricted stock units. If you want to learn how all five kinds of stock compensation work, how they might work together, and how to incorporate them into the rest of your financial picture, get my free guide.]

Why Do Companies Provide ESPPs?

If ESPPs are so awesome for the employee, what’s in it for the employer? While there used to be tax incentives for the employer to provide this benefit, there no longer are.

Instead, “companies are enhancing their employee stock purchase plans in order to retain valued employees, attract new talent and improve morale,” according to this Forbes article. In the go-go world of high tech employment nowadays, you can understand how companies would like any advantage in attracting and retaining employees.

How Does an ESPP Work?

An ESPP allows you to buy company stock at a discount (up to 15%) to the market value.

  1. You choose the percentage of your after-tax income you want the company to deduct from your paycheck to buy the stock. Your company caps the amount you can contribute; a common limit is 10% of salary.
  2. Your company then withholds that money from each paycheck for the entire “Offering Period” (usually 6 months).
  3. At the end of the Period, the company buys the stock for you, at a discount to the lower of two prices:  the stock price at the beginning of the period, and the stock price at the end of the period), with the accumulated money.
  4. You now own some shares of your company’s stock in a taxable brokerage account of your employer’s choice (Fidelity, Schwab, etc.). You own that stock just as if you’d taken money out of your pocket and bought the stock directly through Fidelity or Schwab, etc.

Sounds Good. What’s the Problem?

Not a “problem,” per se. Just an opportunity that you don’t want to squander. Any time you’re dealing with stock compensation, you need to think along three lines:

  1. Tax Planning  
  2. Portfolio Planning
  3. General Planning

Tax Planning

When you acquire the company stock at the end of the Offering Period, you generally don’t owe any taxes. The taxes come into play when you sell the stock.

(By the way, the tax treatment of ESPPs can get pretty hairy, “qualifying disposition” and “nonqualifying disposition” and all that. I paint only a general picture of things here, with the goal of not hurting your brain. If you’re going to actually participate in an ESPP, you’ll benefit from some Detailed Tax Analysis.)

If you sell as soon as possible after acquisition (sometimes there’s a few-day waiting period): you should pay ordinary income tax on the discount amount and hopefully little else because the stock won’t change much in price.

If you sell within a year after acquisition (or within 2 years after the plan becomes available to you): you should pay the same ordinary income tax on the discount amount, but in addition you pay short-term capital gains taxes on any subsequent gains.

If you wait at least one year after acquisition (and 2 years after the plan becomes available to you) to sell: again, you should pay ordinary income tax on the discount amount, and this time you pay long-term capital gains taxes on any subsequent gains. If the stock has fallen in value since you acquired it, it’s possible you will not owe any tax at all.

Long-term capital gains tax rates are lower than short-term capital gains tax rates. Alas, long-term capital gains tax rates aren’t so simple anymore. The base rate is 15%. But if you earn over $250,000 as a married couple (quite likely in the tech industry), it increases to 18.8%. There’s also 20% and 23.8%, and even 0%. Whee!

If you really want to see a numbers-heavy example of how an ESPP might work, check out what TurboTax has to say about it. Don’t say I didn’t warn you.

The Ripple Effects

When you sell, you’ll hopefully get some income out of it (you’ll definitely get income out of it if you sell immediately). And that will ripple through your taxes. That increased income could:

  • Reduce or eliminate some of your itemized deductions (here in Washington state, that is already a fraught calculation because we have no state income tax to itemize!)
  • Eliminate tax credits
  • Subject you to the additional Net Investment Income tax
  • And don’t forget the bogeyman: the Alternative Minimum Tax.

Have you thought about what selling this stock is going to do to the rest of your tax situation?

Portfolio Planning

Imagine this, if you will… You’re on a sandy beach, a mai-tai in your hand… oh, wait, no. Imagine something Much More Boring: the Offering Period has come to an end, and now you have a bunch of company stock in your investment portfolio.

The question now is:  

How much of the company stock should I hold?

It’s easy to build up a large holding if you’ve worked for the same company for years and you’ve been regularly acquiring stock this way and that.

Although I usually prefer to hold no individual stock, you could probably persuade me that 5% of your investment portfolio is a reasonable upper limit. Especially if your persuasion strategy involves Rechuitti truffles.

General Planning

Just as you want a diversified portfolio, you want a diversified financial picture, too. It increases your total financial risk to have both your investments and your job with the same company, as I wrote about previously when Apple’s stock took a big tumble.

Before You Sell the Stock, Think About This

How are you going to pay the taxes due? Out of your salary? With the sales proceeds?

How will the extra income from the sale ripple through your financial situation, analogous to how it might ripple through your tax situation? For example, do you have anything, like health insurance premiums, that is affected by your income level?

Do you have a plan for this extra cash? Are you saving up a house downpayment, or for your kid’s college? Do you have a debt you’d really like to pay off, like a mortgage or auto loan? This could be an opportunity to make some gratifying, instant financial progress.

Living on Less Income 6 Months at a Time

When you participate in the ESPP, your paycheck is going to be lower than you’re accustomed to (because the employer is withholding money for the eventual stock purchase). Can you easily survive on that smaller paycheck?

If you can’t, is it worth decreasing your savings elsewhere so your total take-home income remains the same, and then plowing all the ESPP proceeds back into savings at the end of that 6 months? Or similar cash flow machinations? Do you have the discipline to do that?

My Approach

I don’t invest in individual stocks. I let the market do the thinking for me. This general approach informs my default strategy with ESPPs:

Participate to the maximum, and sell all the stock as soon as possible after receiving it.

Lock in that extra 15%  income (the discount amount), pay the taxes, and put the money in the bank (or, alternatively, a low-cost, broadly diversified portfolio appropriate to your risk tolerance and financial goals).

Not All ESPPs Are Created Equal

Hewlett Packard had an ESPP when my husband worked there. Did we participate? Nope. The discount was only 5%. When I ran the numbers, we would net under $400/year. And let’s face it, if you’re employed in the tech world, an extra $400/year probably isn’t going to be worth staying on top of the stock sale every 6 months (our lives already have enough administrivia in them, you feel me?). Which is to say, just having an ESPP isn’t an automatic win, in my book.

Resources:

MyStockOptions.com

Are you wondering if or how you should participate in your company’s Employee Stock Purchase Plan?  Are you trying to figure out how to make it work with the rest of your finances? Reach out to me at meg@flowfp.com or schedule a free 30-minute consultation.

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Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner and/or an accountant for advice specific to your situation. Reproduction of this material is prohibited without written permission from Meg Bartelt, and all rights are reserved. Read the full Disclaimer.