An employee stock purchase plan is an employee benefit that allows you to purchase shares of your employer’s company stock. It’s a convenient way to buy the shares, thanks to the fact that contributions are often deducted pre-tax directly from payroll.
Some purchase plans offer more than convenience, too, with additional perks like discounts on the share price. This can make participation in a plan seem like a no-brainer. However, before you make the decision to enroll, you should consider potential complications or downsides.
If you maintain a significant position in company stock through your other equity compensation holdings, such as incentive stock options, non-qualified stock options, or other restricted stock units (or awards), adding more exposure through an ESPP may or may not align with the objectives of your overall financial plan.
Or, if you’re risk-averse or otherwise unsure about owning stock, buying shares through an ESPP may not be the right choice for you.
This doesn’t mean you shouldn’t participate — only that you should carefully consider how an employee stock purchase plan fits into your overall financial plan.
To understand why it’s helpful to evaluate some of the key advantages of using an employee stock purchase plan.
How Employee Stock Purchase Plans Work
Let’s begin by making sure you understand a few key terms associated with employee stock purchase plans, and the timelines on which they operate. Generally speaking, an employee stock purchase plan follows this process:
- Enrollment Period – The enrollment period is the time that you can choose whether or not to participate (and enroll) in your employee stock purchase plan.
- Offering Date – The offering date is the date the employee stock purchase plan commences, and deductions from payroll begin. You should note the stock price on the offering date, because it may impact how much you pay to purchase shares of stock and the tax implications when you sell.
- Offering Period – The offering period extends from the offering date, up to a maximum of 27 months, for a qualified employee stock purchase plan.
- Purchase Period – A purchase period may be the entire offering period or a subset of the offering period. Commonly, a purchase period is every six months.
- Purchase Date – A purchase date is the last day of a purchase period. On the purchase date, contributions to the plan are used to buy shares of stock.
Using an example to illustrate how this could work, let’s assume you have an employee stock purchase plan with an offering period of 24 months and a purchase period of 6 months. When you enroll, your contributions to the plan often come right from your paycheck.
These contributions are held in trust during the first 6 months until the first purchase date. On that date, the company uses all contributions from the employees participating in the ESPP to buy shares of stock. This same contribution-and-purchase cycle will occur 3 more times, for a total of 4 purchase dates, until the 24-month offering period ends.
Not all ESPPs operate in such a straightforward manner, and there can be many nuances to the specific one your employer offers. You can look for your ESPP plan document (or request a copy from HR) to dig into the details — but in general, the process above is one that most ESPPs will follow in some form or fashion.
Now that you understand some of the basics, let’s look at why it’s worth considering enrolling and contributing to an ESPP.
1. It’s Usually Easy to Enroll and Get Started with an Employee Stock Purchase Plan
As mentioned, the process to enroll and contribute to an employee stock purchase plan is easy. Your company will typically inform you of your ability to participate in the plan and send the appropriate documentation. If you choose to participate, you notify your employer of that decision by completing the requisite paperwork.
When you enroll, you will need to indicate how much money you plan to contribute. This is often determined as a percentage of your salary or a stated dollar amount. Contributions are often deducted, pre-tax, from your paycheck.
For a qualified employee stock purchase plan, the annual contribution for a plan is typically $25,000. The maximum you can contribute to your ESPP may be limited by several factors, including your income and your plan rules.
2. An ESPP Often Lets You Purchase Shares Below Market Value
On the purchase date of the employee stock purchase plan, contributions are used to buy shares of stock. The cost of the shares may be equal to the fair market value of the stock on the purchase date — but many ESPPs include certain provisions like a purchase price discount and a lookback provision.
A purchase price discount is just as it sounds: if your company offers a discount, you will be able to purchase shares for less than you would have otherwise been able to do so. Typically, the discount is between 1 and 15% off the fair market value.
A lookback provision is a second feature that may positively impact the price you pay to purchase shares of stock. If your company offers a lookback provision, the ESPP will buy shares of stock at the better of the offering date price or the purchase date price.
Should the stock price increase between the offering date and the purchase date, you pay the lower grant date price of the stock. Should the stock price decrease between the offering date and purchase date, you pay the purchase date price.
The potential discount on share price and the lookback provision are great on their own — and some employee stock purchase plans offer both benefits. If your ESPP gives you the opportunity to use both, the two benefits can be “stacked.” That allows you to enjoy a discount on a lookback price.
3. You May Pay Long-Term Capital Gains on Some of the Proceeds
If you have a qualified ESPP, you do not owe any taxes when shares are purchased through the ESPP on your behalf. When you sell these shares, however, you create a taxable event that you must report when you file income taxes.
How you report this taxable event, and the subsequent tax due because of it, will depend on whether or not you achieved a qualifying disposition or a disqualifying disposition.
A qualifying disposition is a final sale of employee stock purchase plan stock that occurs at least 2 years from the offering date of the plan and 1 year from the purchase date of the shares. Anything that doesn’t meet both of these two rules is a disqualifying disposition.
If you have a qualifying disposition that has a gain, you may be able to pay long-term capital gains taxes on some of the taxable gain. Long term capital gains tax rates are lower than rates you’d otherwise have to pay if you were taxed at your ordinary income tax rate.
But there’s a downside of trying to achieve a qualifying disposition just so you can secure a favorable long-term capital gains tax rate: You have to buy and then hold the shares for at least one-year post-purchase. During this time, the stock price can go up and down, exposing you to market volatility and risk of loss of value.
4. You May Not Pay Social Security or Medicare Tax on Some of Your ESPP Profits
The nuance of income tax with an employee stock purchase plan can be complicated, and is beyond the scope of this article — but to give you a quick overview of this benefit, when you sell your shares via a qualifying or a disqualifying position, you will likely need to report some combination of compensation income and short- or long-term capital gains income.
You do not, however, need to report income that would be subject to Social Security or Medicare payroll tax. This may be different from other equity compensation that you may have, like non-qualified stock options or restricted stock units.
5. A Good ESPP Might Increase Your Overall Income
An employee stock purchase plan that offers a purchase price discount or a lookback provision might be an opportunity to increase your overall income and net worth — even if you already own a significant position in company stock. Here’s why:
Let’s assume that you participate in a plan and that you are allowed to purchase shares at a 15% discount. Then, you sell those same shares immediately after the purchase date. The plan’s discount may reduce the potential investment risk associated with participating in a stock plan.
Regardless of the purchase price and the potential tax bill associated with the sale, you may end up with more after-tax money than you would have had you not participated at all.
This possibility is a byproduct of buying something at a price that is less than what you sell it for. If you have this ability due to the features of your ESPP, it seems like something to consider this as part of your financial plan. Along with understanding how your ESPP works and how you may benefit from it, you will want to confirm that your plan allows for you to sell your shares immediately after they are purchased, or that you aren’t otherwise prohibited from selling.
Moving Forward with Your Employee Stock Purchase Plan
Employee stock purchase plans can be a great benefit to leverage because they allow for easy enrollment and purchase of company stock.
With the right provisions, ESPPs can also provide you with a quick, simple way to buy shares below market value and then immediately resell at market price to lock in a profit equal to your discount. If you also have a lookback provision? Even better. And of course, the potential for an appreciating stock price is always nice, too.
Just make sure you have a strategy in place to manage your cash flow before jumping into an employee stock purchase plan.
Remember that contributions usually happen via payroll deductions, so participating in an ESPP probably means less take-home pay. You also want to assess the investment risk of holding a more concentrated position, and evaluate how you will do your tax planning going forward to account for the added complication of buying and selling these shares.
Thanks to the benefits and features of these plans, ESPPs can be a great way to generate meaningful wealth.
The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment. Diversification does not guarantee a profit or protect against a loss. None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation. Tax services are not offered through, or supervised by, The Lincoln Investment Companies.