Getting Free Money from Your Employer with ESPP

Many people receive the benefit of being able to invest in their company stock at a discount.  However, not everyone maximizes that opportunity.  Let’s review Employee Stock Purchase Plans (ESPP) and how you can potentially maximize your benefit.

Employee Stock Purchase Plan Background

With Employee Stock Purchase Plans, you share in your company’s success.  Companies offer these as part of your benefits as a way to foster employee loyalty. 

ESPPs have an enrollment period where you sign up to be involved with the purchase period (6 months at Nike & Intel).  The maximum amount that can be contributed is usually 5% or 10% of salary with a maximum contribution of $25,000/yr.  Both Nike and Intel offer a discount of 15% to where the stock is trading in the market.  This can be a great deal because if the stock appreciates, you are rewarded with more profit than the investor who purchased the stock at full price.

1. Why ESPP is a great deal

Let’s assume the stock has a 6-month enrollment period with a 15% discount from the beginning or end of the enrollment period, whichever is most advantageous.  When ESPP contributions come out of your paycheck, they come out each paycheck during the enrollment period.  Money from the beginning of the enrollment period waits 6 months before stock purchase, where money at the end of the enrollment period essentially waits 0 months before stock purchase.  Since money is coming out of each and every paycheck, the average amount of time before purchase is (6 months – 0 months)/2 or 3 months.

What type of annualized return are we talking about by using ESPP?  Let’s start by calculating the return on your money when the stock purchase is implemented.  When you get 100% of the value on the stock purchased and receive a 15% discount, the instantaneous return is really the 17.6% shown below.

In the figure above, the average holding period of the money for the purchase of stock is 3 months (or 0.25 years). 

I don’t know of any other investments that guarantee a 70+% annualized return.  For this reason, putting in the maximum amount possible into your company stock is generally the right decision.

Some companies allow you to sell the stock right away and other companies have a required holding period.  When you sell right away versus holding for a longer period of time, there are tax consequences to consider.

2. Concentrated Stock Positions

Ok, so now you understand how buying company stock can be a great deal!  How much of company stock should you accumulate?  If you put away 10% of wages for 10 years and your company stock stays stable in price, you could end up with a year’s salary in your ESPP account.

The company you work at may be great.  However, if you worked at Worldcom or Enron, how much company stock would you have wanted to have held when they crashed? Having a good portion of your net worth in a single company puts investors at risk of a financial calamity.  We think a systematic strategy for diversification makes sense to capture the discount, take advantage of the tax rules and lower your financial risk.  Let’s talk about how long you should hold your money before you diversify out of your employer’s stock.

3. Short and Long Term Capital Gains

There are two types of taxable gains. 

  • Short Term Capital Gains are for stock holdings held a year or less and are taxed at your marginal tax rate. In 2018 marginal tax rates can be as high as 37% federal + 9.9% OR state tax rate
  • Long Term Capital Gains are for stock holdings held 1 year and a day or more since purchase and typically taxed at 15% or 20% depending on your income level (consult with your tax professional for your personal rate)
  • ESPP taxation is unique. If you hold your shares for more than a year after the purchase date AND more than two years after the beginning of the offering period then any profit above the gain from the discount with be taxed at capital gains tax rates.  If you don’t, then gains attributable to the discount will be taxed at ordinary rates.

Often times your employer will show the value of the ESPP discount on your W-2 and you can pay taxes twice.  Working with a tax professional can potentially save you unnecessary tax payments.

March 22, 2018

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