Consider it a bonus! Why you should invest in your company’s ESPP.
An Employee Stock Purchase Plan, known as an ESPP, is an employee benefit program within public companies that allows you to buy company stock at a discounted rate. In most plans, you may contribute up to the lower of 15% of your compensation or $25,000 each year. Companies will offer discounted stock to their employees through payroll deductions during an offering period (typically 12-24 months) split into purchasing periods (typically quarterly or semi-annually).
For some, shelling out an extra almost $2,100 per month to hit the maximum participation in the ESPP is a relatively easy adjustment, and for others, this might be a large portion of their compensation. In today’s blog, we’re going to explain the ins and outs of an ESPP, and give you strategies on how you can maximize your ESPP, whether you fall into the former or the latter. Whatever you decide, keep in mind that it’s a balancing act of managing cash, taxes, and concentrated stock risk.
The Types
Before we dive into the strategies, we want to explain the relevant terms we’ll be using throughout this blog on how ESPPs work.
To start, there are two types of ESPPs: qualified and non-qualified. Among companies today, qualified plans are the most common. An easy way to figure out if your plan is a qualified plan is to check your ESPP plan documents. If you have a “Section 423 ESPP” then your ESPP does qualify under the US Tax Code and it means:
You can purchase company stock at a discount.
You can postpone recognition of tax on the discount you received until the shares are sold.
Further tax benefits may be available based on how long the shares are held.
A non-qualified ESPP does not offer the employee-related tax advantages described above. Unlike a qualified plan, applicable taxes on non-qualified ESPP shares are due at purchase. Nonqualified plans are not subject to the rules that pertain to qualified plans, but there is no tax advantage of any kind in these plans.
The Dates
There are a lot of dates to wrap your head around when it comes to ESPPs, and companies may not always use the same nomenclature when educating their team on participation rules. These dates are important to be aware of regardless of whether you are participating in a qualified or non-qualified plan; however, if you are considering holding stock from your qualified ESPP over the long run, you’ll want to pay special attention to the grant date (sometimes called the offering date) and the purchase date. In order to qualify for preferential tax treatment, you will need to hold the stock for at least two years from the grant date and one year from the purchase date.
The timeline of an ESPP looks like this:
First, there is a period in which you may enroll for your ESPP. The enrollment period is typically one month, with the enrollment deadline likely falling on or around the grant date, which aligns with the start of the offering period. During the enrollment period, you will be able to elect what percentage of your payroll you would like to contribute to your ESPP during the offering period. Within an offering period, there may be one or more purchase periods. In our example above, there are two purchase periods. The purchase date represents the day your company takes your payroll deductions and invests that money into your company’s stock.
The Lookback Provision
By electing to participate in your company’s ESPP, you get to buy your company’s stock at a discount. If your company offers a lookback, then you will purchase stock at a discount using the lower of the price on the Grant Date or the Purchase Date. What this means is that you are able to get a discount on the lower of two valuations - the price at the beginning of the offering period, or the stock price on the purchase date.
If your company does not offer a lookback, then you will purchase stock at a discount using the price on the purchase date.
As an example, let’s say your ESPP offers a 15% discount, and your company’s stock is $15 at the beginning of the 12-month offering period and $20 on the day of purchase.
With a lookback, you would be able to buy the stock at $12.75, or 85% of $15, even though the stock is trading at $20/share. Without the lookback, then you would be able to buy the stock at $17, or 85% of $20. Obviously, we love a lookback provision!
The Strategies
Signing up for your ESPP is similar to electing your 401k contributions, with the difference being that you may only sign up during specific enrollment periods. The number of enrollment periods varies, but typically ranges from one to four times per year. The IRS limits contributions to your Employee Stock Purchase Plan (ESPP) to a pre-discounted $25,000 per calendar year. So, if your goal is to max out your ESPP (and we hope by the end of this blog, it will be!), then divide your annual compensation by $25,000. The result of this calculation is the percentage you should elect to defer into your ESPP. For example, if you’re earning $250,000 per year, you would want to elect 10% as your contribution. You’ll also want to check if your annual compensation calculation includes your salary and bonus (you’ll find this in your ESPP enrollment documents).
You’ll notice deductions on each paycheck during the offering period equal to the amount you are contributing to the ESPP. To check that you are enrolled correctly, you should ensure that your monthly deposits are $2,083 less than they previously were. This money goes into an account in escrow in your name, and typically the company will provide you with a date in which you are able to ‘undo’ the transaction. However, assuming you proceed, the money you contribute over the purchasing period will aggregate, and then on the purchasing date, you will receive shares of your company’s stock.
Strategy 1: Buy & Hold
If you’re looking to build an investment in your company’s stock, an ESPP is a great way to do so. If the stock price is going up, the greatest tax benefit you can receive from an ESPP occurs when you hold the shares for at least two years from the Grant Date and one year from the Purchase Date. Upon sale of the shares, you’ll pay ordinary income on the discount received, and then any profit above the gain from the discount will be taxed at long term capital gains rates.
Many individuals who get access to an ESPP also receive compensation in the form of Restricted Stock Units (some blog links for you below). If this is you, it’s important to consider how much concentration you have in your company’s stock. This is a highly personal question, and considers factors such as risk tolerance, risk capacity, current savings, net worth, and your investment portfolio. We recommend working with a financial planner to evaluate what is right for you. However, if your stock price is going up, and you’re looking to divest, don’t stop your ESPP. Instead, consider maintaining your ESPP strategy, while selling your RSUs.
Strategy 2: Consider It a Bonus
For many individuals, the opportunity cost of $25,000 per year is too great. An extra $2,100 per month could cover childcare costs, college education funding, property taxes, or rebuilding an emergency fund. Oftentimes, our clients with young children in expensive cities have high essential expenses. In these scenarios, we opt out of the tax optimization and instead focus on cash flow.
If you are unwilling or unable to allocate $2,100 of your income each month to an investment in your company’s stock, then it’s ok to sell your ESPP-purchased shares on or right after the Purchase Date. The discount offered by ESPPs typically ranges from 5-15%. If you signed up for your ESPP, and there was no lookback, we would expect your pre-tax gain each year to be:
5% discount = $1,316 / year
10% discount = $2,778 / year
15% discount = $4,412 / year
You’ll pay ordinary income tax on the discount you receive, but because you’d be selling the shares before they have any time to gain or lose value, there likely won’t be any additional tax you’ll have to pay. Additionally, by selling right away, you reduce the risk of the stock price going down after the Purchase Date, locking in your discount as a bonus to you!
Creating an Elegant System
Regardless of which strategy you choose, we like setting up an account structure that simplifies that work you have to do. We recommend linking your ESPP custodian (like E*Trade, Fidelity, or Schwab) to your high-yield savings account, so when you do make a sale, you transfer it to savings.
If you’re operating under the Buy & Hold strategy, we’ve seen that transferring money to savings (instead of checking) gives clients a higher likelihood of reallocating any proceeds to investments for their short-, mid-, and long-term goals. If you’re operating under the Consider It a Bonus strategy, we like when clients transfer the full liquidated balance to their savings account, and then set up an automatic monthly transfer from their savings to their checking at $2,083/month. This means that the bonus stays in savings, and can also be reallocated to short-, mid-, and long-term goals!
We love elegant systems at Mana, and believe that optimizing investments and automating savings and account structures can propel individuals and families to achieving even greater financial freedom than anticipated.
For more Mana Moments blogs on stock compensation, check out the below:
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Stephanie Bucko and Cristina Livadary are fee-only financial planners based in Los Angeles, California. Stephanie is the Chief Investment Officer and Cristina is the Chief Executive Officer at Mana Financial Life Design (FLD). Mana FLD provides comprehensive financial planning and investment management services to help clients grow and protect their wealth throughout life’s journey. Mana FLD specializes in advising ambitious professionals who seek financial knowledge and want to implement creative budgeting, savings, proactive planning and powerful investment strategies. As fee-only fiduciaries and independent financial advisors, Stephanie and Cristina never receive commission of any kind. Stephanie and Cristina are legally bound by their certifications to provide unbiased and trustworthy financial advice.