How Does an Employee Stock Purchase Plan Work (ESPP)?
An Employee Stock Purchase Plan (ESPP) is an employer-sponsored program that allows employees to buy stock in their company at a discounted price. If used correctly, ESPPs can be a very effective wealth-building tool, effectively allowing your employer to subsidize the purchase of a portion of your investment assets.
If you’ve spent much time on this site, you know we’re big fans of employer matching opportunities.
Even if employer contributions do not come on a dollar-for-dollar basis, they can be quite valuable.
Just such an opportunity exists in Employee Stock Purchase Plans (ESPPs).
While not really a “mainstream” investing topic, an Employee Stock Purchase Plan shouldn’t be overlooked if you have access to one.
Let’s unpack ESPPs a bit more.
What is an Employee Stock Purchase Plan?
An Employee Stock Purchase Plan is an employer-sponsored program that allows employees to buy stock in their company at a discounted price.
Normally, the shares are offered at a discount of 15% of the stock’s market price when the shares were offered or purchased for the employee, whichever is lower.
How Does an Employee Stock Purchase Plan Work?
Employees who elect to participate in an ESPP have a portion of their paycheck set aside each pay period in order to purchase shares of company stock.
The period between the date the discounted shares are offered and the date they’re bought for the employee is known as the offering period.
At the end of the offering period, the employer uses the accumulated money withheld from employee paychecks to purchase shares on the employee’s behalf.
Once the shares are purchased, they are placed in an account with the employer’s selected Employee Stock Purchase Plan custodian.
There could be limitations on when an employee can sell their Employee Stock Purchase Plan shares. For most qualified plans, you’ll have to own the stock for at least one year before it can be sold.
Many plans also require a year or more of employment with the company before you are eligible to participate in the ESPP.
Finally, in Qualified ESPPs, employees cannot purchase more than $25,000 of employer stock in a calendar year.
Qualified vs. Non-Qualified ESPPs
There are two types of Employee Stock Purchase Plans: Qualified and Non-Qualified.
Qualified ESPPs (also known as Section 423 Plans) allow the shares to be purchased at a discount without any taxes being owed on the discount at the time of purchase.
Non-qualified ESPPs operate similarly to Qualified ESPPs but lack the same preferential tax treatment at the time of purchase.
Speaking of taxes…
How Are Employee Stock Purchase Plans Taxed?
ESPP taxes can get pretty complicated.
Generally, Employee Stock Purchase Plans are taxed like a regular stock. If you own the shares for more than one year, the gains on the stock are taxed at long-term income tax rates.
The discount amount (usually 15%) is taxed at your regular income tax rate when the shares are sold.
For example, let’s assume you buy $5,000 of ABC stock through an ESPP. The purchase costs you $4,250 ($5,000 * 0.85).
Let’s also assume that you hold the shares for two years and decide to sell them for $8,000. Furthermore, we’ll assume that you are in the 22% income tax bracket and the 15% capital gains bracket when you execute the sale.
Your tax liability will be 22% of the $750 discount ($5,000 – $4,250), plus 15% of the $3,000 capital gain ($8,000 – $5,000), for a total tax owed of $615 ($165 + $450).
Non-qualified ESPPs are taxed similarly to non-qualified stock options.
Income tax is owed on the discount amount at the time of purchase. When the shares are sold, capital gains and income tax rules apply depending on how long you held the shares.
How Common Are Employee Stock Purchase Plans?
To begin, your company would need to have shares of stock available for purchase in order for you to be able to buy them through an ESPP.
So, the smaller and more private your company is, the less likely you are to have access to an Employee Stock Purchase Plan.
According to Aon Human Capital, about 49% of companies in the S&P500 and 38.5% of Russell 3000 companies offered an ESPP to some portion of their employees.
ESPPs also tend to be more common in the technology, healthcare, financial, and communications industry sectors.
You are also more likely to have access to an ESPP as your level of responsibility within an organization increases.
When Should I Buy Employer Stock Through an ESPP?
There are a couple of things to consider before participating in an Employee Stock Purchase Plan.
First, you should remember that your employer is probably already your primary source of income. Buying employer stock isn’t going to add any diversification to your financial situation.
Being laid off at the same time your ESPP shares plummet in value is a textbook example of insult added to injury.
If you’re too dependent on income, earnings, or both from one company you could be setting yourself up for serious disappointment.
I wouldn’t buy more than 5% to 10% of my overall investment portfolio in a single company stock, especially not the one I work for.
With that said, the ability to buy company stock at a 15% discount is effectively a free money opportunity.
After all, at a 15% discount, that’s fifteen cents of every dollar you save given back to you by your employer. I’d like a 15% raise, wouldn’t you?
I can easily make an argument that you could participate in an ESPP as part of Milestone 2 on the Next Dollar Roadmap.
So, cutting to the chase here, IF…
- I felt like my company’s financial position was strong,
- The ESPP restrictions didn’t prevent me from selling the stock after owning it for one year,
- I’ve already exhausted other matching options available from my employer,
I’d consider buying employer stock through an ESPP until its cumulative value along with all other employer matching savings vehicles was between 15% and 25% of my gross income.
Put another way, if I still had debts to pay off, I’d cap the Employee Stock Purchase Plan and other matching savings at 15% to 25% of my income so I could focus on paying off my other debts.
If you’re past milestone 4 (fully funded emergency fund), then buy it up to the $25,000 annual max or whatever amount you’re comfortable with.
Buying the max is a no-brainer if you’re on Milestone 6, Invest for Flexibility. Again, it’s free money. Go get it.
When Should I Sell Employer Stock Through an ESPP?
Once a year has passed and you’ve received the full value of your discount, sell the stock per the terms of the Employee Stock Purchase Plan as soon as you are able to.
Just by purchasing employer stock, you’ve assumed more risk by compenetrating your assets with one company.
So, buy it.
Wait a year.
Sell it.
Rinse and repeat.
Once you’ve sold the stock, take that cash and invest it per Milestone 6 which we’ve linked above.
Assuming your company’s stock price doesn’t tank before you can sell it, following this process effectively provides you with a 15% subsidy for the purchase of other investments.
Thanks, boss!
Average J’s Employee Stock Purchase Plan:
Let’s follow our old friend, Average J, through an example.
Let’s assume Average J works for XYZ Company and has access to both a matching 401(k) (dollar for dollar, up to 4%) and an ESPP.
Average J has no debt and a fully funded emergency fund which puts her on Milestone 5 of the Next Dollar Roadmap.
Currently, in 2023, the median individual income in the United States is $44,225 per year.
So, if Average J saves 4% of her income ($1,769.00 annually) and XYZ company contributes another 4%, she’ll have a total of $3,538 placed in her 401(k) each year.
This represents 8% of her annual income, which is still a bit short of her 15% goal.
To make up that other 7%, Average J decides to purchase $3,642.06 of XYZ shares each year through the ESPP which will cost Average J $3,095.75 after she receives her 15% discount.
Through the Qualified ESPP, Average J will be able to sell her shares one year after they are purchased.
During the year Average J is waiting to sell her shares, the price of the stock rises 6.5%, producing a capital gain of $236.73.
Average J’s adjusted gross income will put her in the 12% income tax bracket and the 0% capital gains bracket.
As a result, her net tax liability for the ESPP is only $65.56 which is 12% of the discount given to her by her employer through the ESPP.
Once Average J sells her shares, she uses the proceeds to purchase $3,878.79 of her favorite ETF, VOO.
In summary, by using her employer’s ESPP, Average J has $3,878.79 of assets that cost her $3,161.31.
The rest was subsidized by XYZ Company and the gains she earned during the year she waited to sell the shares.
Conclusion
Employee Stock Purchase Plans can be very beneficial for building wealth, but they are complicated.
Be sure you understand the specific rules of your own ESPP and the financial wellness of your company before making a large ESPP commitment.
