If you work at a tech company, there’s a good chance you’re eligible to participate in an employee stock purchase plan (ESPP). These plans typically allow you to buy company stock at a discount in the range of 5% to 15%.
Participating in these plans can provide a nice boost in your wealth-building journey. In this month’s article, we’ll discuss the basics of an ESPP along with a few strategies.
ESPP 101
ESPPs are purchased with after-tax dollars via payroll deductions. When you sign up for your ESPP, you’re typically allowed to contribute up to $25,000 annually to buy shares. However, the discount reduces the $25,000 in a given calendar year. For example, if you sign up for an ESPP with a 15% discount, the most you can contribute for that year is $21,250 ($25,000 *0.85).
Each company may have slightly different purchasing frequencies throughout the year. Still, every plan has an enrollment date and a purchasing date. The enrollment date is when you enroll in the program and select how much you want to contribute. The purchasing date is when you can buy shares at a discount.
However, some companies have a lookback feature, which allows you to buy company shares at the lower of either the enrollment date or the purchasing date. As we’ll show you, these types of plans are the best.
Taxes
The majority of ESPPs are tax-qualified under Internal Revenue Code Section 423. The taxes on ESPPs can be reasonably confusing. Your tax comes down to your holding period, specific discount, lookback period, and if you met a qualifying holding period.
If you sell the shares immediately at purchase, the discount is subject to ordinary income rates. For example, if you buy company shares trading at $10 for $8.50. That $1.50 discount is subject to your marginal tax rate.
If you hold the shares a little longer, you’ll have an ordinary income component and a capital gain or loss. If you own the stock two years from the offering period and then one year from the purchase date, you’ll have a qualifying disposition. In this case, the majority of your gain will be subject to the lower capital gains rates.
As an added benefit, regardless of when you sell, Section 423 ESPPs are not subject to FICA taxes, i.e., 6.2% Social Security and 1.45% Medicare taxes.
The key thing with an ESPP is to keep good records. If you end up holding the shares longer, you’ll want to make sure your cost basis is correct when filing taxes. This can save you a lot of time and money. I’d recommend working with a CPA or Enrolled Agent to prepare your tax return.
Strategies
With RSUs, an ESPP, and potentially stock options, it’s easy to become overly concentrated at a tech company. No matter how well your company’s stock is performing, you still want to avoid holding too many shares. Having all of your eggs in 1 basket is rarely the wisest strategy. And I would argue it’s not a strategy at all, but a gamble. Research has shown that 64% of individual stocks underperformed the U.S Market represented by the Russell 3000 Index. A good starting point is making sure one stock does not exceed 5% of your investable net worth.
If your ESPP has a lookback period, it can be an excellent tool to lock in a guaranteed profit.
For example, let’s assume your ESPP has a 15% discount with a lookback feature. If shares cost $10 at the offering period and $12 at the purchasing period, you’ve bought shares at $8.50. If you sell shares immediately at $12, your gain is $3.5 per share or a 41% return!
Now, even if the stock price drops, you still profit! Let’s say shares cost $10 at the offering period and later fall to $1 at the purchasing period. You’ll buy shares for $0.85 and sell at $1, which is a 17.65% return. Even after paying ordinary income tax, your after-tax return is still significantly higher than average market returns. Risk-free returns like that don’t exist anywhere else. To give you some perspective, the S&P 500 average about 10% per year. However, that 10% is certainly not guaranteed.
The guaranteed cash flow generated from an ESPP can be used to pay off high-interest debt, diversify into other investments, help you save for a home down payment, or could even cover a portion of an IRA contribution. The point is, by participating in an ESPP, you have tools. And financial planning is all about using tools to your advantage. Even if your ESPP has a discount of less than 15%, it can still be beneficial to consider enrolling.
Key Takeaway
Leveraging an ESPP throughout the years to build wealth takes a significant amount of discipline. Without a plan or cohesive strategy, you may be more prone to making last-minute, emotional, or irrational decisions that you can’t undo. When you have a plan, you’ll know all sides of the equation - the amount of company stock in relation to your overall portfolio, your core goals, your current tax status, next year’s tax, etc. When you can see the entire picture, making financial decisions becomes much more comfortable and less stressful.
If you’re looking for custom guidance from a CERTIFIED FINANCIAL PLANNER™ on maximizing your ESPP, reach out to schedule an initial consultation.
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