Participating in an employee stock purchase plan (ESPP) can offer many financial planning benefits. Depending on the plan type, these could include stock purchase price discounts and favorable tax treatment if the shares are held for a specified period of time.
Here are 10 essential rules that you should understand when deciding if you want to participate in your company's ESPP.
Rule No. 1: Set Goals
All financial planning starts with setting goals. To get started, ask yourself:
- What exactly do I want to do with the proceeds from the eventual sale of the shares?
- How much can I comfortably contribute from my salary toward those goals, given my current cash needs?
Maybe you want to use the sale proceeds for a down payment on a house, a renovation or a child's college tuition. Coming up with concrete goals can help to clarify your use of the shares in relation to your income and other savings.
Rule No. 2: Know What Type of ESPP Your Company Offers
There are two types of ESPPs: tax-qualified and nonqualified. It is vital to know which you have.
- Tax-qualified ESPPs generally let you buy shares at a discount of up to 15% from the stock price without owing any taxes on the discount spread at purchase. The IRS lets you buy up to $25,000 worth of shares during any calendar year, though your company may impose a lower limit.1 No tax applies until you sell the shares. And, if you hold the shares long enough to meet the statutory holding periods for favorable tax treatment, a portion of your gain is taxed as long-term capital gains when you sell the shares.
- Nonqualified ESPPs work in the same way but without the IRS rules and favorable tax treatment of qualified plans. A purchase discount (if any) produces taxable ordinary income.
Note that state and foreign (non-US) tax consequences may vary.
Rule No. 3: Know How Purchase Periods Work and Learn the ESPP Life Cycle
During a purchase period, payroll deductions are accumulated to purchase shares on your behalf. Shares are typically bought on the purchase date at the end of the purchase period (which is usually a shorter time period within the offering period). You must then decide whether to sell or hold the shares.
Remember that ESPPs vary among companies. You should know the key dates, the maximum you can contribute under your plan rules and how you can withdraw from the offering. To get a full understanding of your company's ESPP, you should carefully review brochures, FAQs and any other materials about the plan. You should also review enrollment forms, along with the terms, conditions and company procedures.
Rule No. 4: Understand Purchase Discounts and Lookbacks
Your company will specify the purchase price discount before the offering period begins (e.g., 1-15% of the fair market value of the price per share of company stock). If your plan has a lookback feature, the discounted purchase price that you pay is based on the stock price at either the start or the end of the offering period, whichever is lower.
Rule No. 5: Understand the Impact of Job Termination
Generally, if you leave the company, you will continue to own shares that you purchased during your employment, but your eligibility for participation in the plan ends. Any funds withheld from your salary but not used to purchase shares before the end of your employment will be returned to you, normally without interest, within a reasonable period. Be sure to check your plan’s rules for the impact of leaving your company for your specific circumstances.
Rule No. 6: Know the Timeline of the ESPP Holding Periods
If your ESPP is tax-qualified, the tax consequences depend on whether you meet the holding periods required for favorable tax treatment and whether you are selling the shares for more or less than the purchase price. For beneficial tax treatment, you must hold the shares for more than one year from the date you purchased the shares and two years from the offering date.
Rule No. 7: Understand ESPP Taxation
The taxation of ESPPs can be confusing. You may owe taxes either in the year you purchase shares and the year the shares are sold, or only when the shares are sold. Your tax treatment is determined by the type of plan offered by your employer, and for tax-qualified ESPPs, how long you hold the shares after both the offering date and your purchase date.
Tax-Qualified ESPPs: Holding Periods Met
You may have both ordinary income and capital gains if you sell your shares after you meet the holding periods. The ordinary income recognized equals the lower amount of either:
- Your actual gain (sale price minus purchase price), or
- The purchase price discount
For tax purposes, the purchase price discount is computed as of the first day of the offering period. This applies even when the purchase price is based on the lower value of the stock on either the first or the last day of the offering period (i.e., a lookback provision) and that starting price is higher. All additional gain upon the sale of stock will be treated and taxed as long-term capital gains. If you sell the shares for less than your purchase price, you will have a long-term capital loss equal to the difference between the sales price and the purchase price.
Tax-Qualified ESPPs: Holding Periods Not Met
If you sell the shares without satisfying the ESPP holding periods (i.e., before one year following the purchase date and two years following the offering date), you recognize ordinary income. The amount of ordinary income is equal to the difference (the spread) between the fair market value of the stock at the date of purchase and your purchase price.
Nonqualified ESPPs
The favorable tax treatment does not apply to nonqualified ESPPs. For example, when the purchase price is discounted from the fair market value on the purchase date, the spread is taxed at the time of purchase as ordinary income and income and employment taxes are withheld. Any additional gain on a later sale above the fair market value on the purchase date is taxed as capital gains. This can be short- or long-term, depending on how long the shares are held after purchase.
Rule No. 8: Know Whether You Want To Sell or Hold the Shares After Purchase
The decision to sell or hold the purchased shares depends on various factors.
- Tax planning: Whether you hold the shares and for how long will affect your tax treatment when you sell them.
- Your individual needs: Your cash needs, upcoming life events and other financial planning factors, including diversification, dividends paid on your company's stock and alternative investments will all impact if and how long you want to hold the shares.
- Sale restrictions: Be aware of any company-imposed mandatory holding periods and any company trading blackouts that prohibit transfers of shares. Executives must be mindful of stock ownership and/or retention guidelines that may require them to keep a certain amount of company stock.
Rule No. 9: Watch Your Tax Rates in the Year of Sale
You may want to anticipate what your tax rate will be in the year when you plan to sell any ESPP shares. Any income spike, e.g., from a bonus or a vesting of restricted stock units (RSUs), can have a significant impact on your capital gains tax rate. Yearly income above certain thresholds may raise your rate of capital gains tax from 15% to 20% on any shares you sell and could trigger an additional surtax of 3.8%.
Example: You hold ESPP shares that you may want to sell this year. However, your RSUs vested this year, and you received a large bonus, pushing your income into the highest tax bracket. You may want to think carefully before selling your ESPP shares in the same year to minimize your overall tax liability. Keep in mind that if you trigger the higher capital gains tax rates, you may pay up to 23.8% in taxes (20% capital gains tax plus an additional 3.8% surtax), while if your income remains below the related income thresholds, you will generally pay just 15% in capital gains tax and not trigger a surtax.
Rule No. 10: Beware of Overconcentration in Company Stock and Consider Diversification
"Don't keep all of your eggs in one basket." This good advice neatly encapsulates the dangers of stock concentration and the importance of investment diversification. When you participate in an ESPP, as you make purchases over time, it may be easy to forget how much of your net worth is contingent upon your company's stock performance. The danger of overconcentration may leave you vulnerable in times of severe market volatility, so it’s important to know how much your holdings in company stock contribute to your overall net worth.
The Bottom Line
Participating in your company’s ESPP has many benefits, especially if it is tax-qualified. Understanding how ESPPs fit into your overall financial plan is key to determining the portion of your portfolio that should be allocated to company stock. If you are not comfortable making these decisions on your own, you may want to consult with a Financial Advisor for help in devising an ESPP strategy that will help you meet your financial goals.