Employee stock purchase programs – ESPPs for short – are powerful employee benefit programs that, when used correctly, offer what is essentially a guaranteed investment return of at least 17.6 percent.
But ESPPs are often misunderstood and misused. People either fail to use them at all, which is a missed opportunity, or use them incorrectly, which adds unnecessary risk to their investment portfolio.
This article will explain exactly how ESPPs work and how to use them the right way so you can capture that guaranteed return without taking on any undue risk.
What Is an Employee Stock Purchase Program (ESPP)?
An ESPP is an employee benefit program that allows you to buy company stock at a discounted rate.
While the specifics of ESPP plans differ from company to company, and while you should definitely refer to your company’s plan documents before taking any action, most ESPP plans looking something like the following:
- There is a 12-month offering period split into two different six-month purchasing periods.
- Before the offering period starts, you elect to contribute a certain amount of money to your ESPP.
- Once the first purchasing period starts, that contribution is deducted from your paycheck. There is no tax deduction for your contributions.
- At the end of the first purchasing period, the money you’ve contributed is using to buy employer stock at a 15 percent discount.
- That discount is applied to the LOWER of the stock price at the beginning of the purchasing period and the stock price at the end of the purchasing period.
- You can either sell that stock immediately, in which case the gains are taxed as ordinary income, or hold onto it for at least one year after the purchase date and two years after the beginning of the offering period, in which case the gains are taxed as long-term capital gains.
- Steps 3-6 are repeated for the second six-month purchasing period.
- Steps 2-7 are repeated for the next 12-month offering period.
Step #5 is where the real power of the ESPP comes into play. Because not only are you getting a 15 percent discount on the price of your employer’s stock, but you’re getting a discount on the lower of two prices, which means you stand to gain quite a bit no matter what happens.
Let’s say that your employer’s stock is at $10 at the beginning of the purchasing period, and at the end of the period it’s at $5. Even though the stock has gone down, you get to buy it at a 15 percent discount on the $5 price because that’s the lower amount. That is, you can buy it for $4.25 and immediately sell it for $5, which equates to a 17.6 percent gain.
Now, let’s say that the stock price goes up from $10 at the beginning of the purchasing period to $15 at the end of that period. This time you’d get to buy the stock for $8.50, which is a 15 percent discount on the lower $10 price, and immediately sell it for $15. That comes out to a 76.5 percent gain.
In other words, the worst-case scenario* if you sell immediately is a 17.6 percent gain, and the best case scenario is essentially unlimited.
Not bad, right?
*The actual worst-case scenario is that your company goes bankrupt during the purchasing period, in which case you would lose the money you contributed. This is one of the big differences between an ESPP and a 401(k) and other qualified retirement plans since those plans are protected from bankruptcy.
How to Take Advantage of Your ESPP
With that background, how can you take full advantage of your ESPP and avoid the most common mistakes?
Here are five steps you can follow.
1. Max out other retirement accounts.
In general, it’s a good idea to max out your other retirement accounts before contributing to an ESPP. The tax breaks offered by those accounts are generally better than the discount offered by an ESPP.
2. Read your ESPP plan documents.
While the example above is typical of most ESPP plans, every company has its own policies, and you should make sure to understand exactly how your plan works before jumping in.
3. Contribute the maximum amount your budget can afford.
Assuming your plan works generally as described above, and assuming your other financial priorities are handled, you can elect to contribute as much as your budget can afford, up to the maximum allowed contribution.
4. Sell the shares as soon as you receive them.
This is the step that a lot of people get wrong.
Because there’s a tax benefit to holding onto the shares, many people do just that. The problem with that strategy is that owning employer stock is incredibly risky, and by holding onto it you’re introducing the possibility of a big loss that more than wipes out the guaranteed return you’ve already earned.
The right strategy, therefore, is almost always to sell the stock as soon as you get it. Not only does that lock in the guaranteed rate of return, but you can then use the proceeds to do things like build a more diversified investment portfolio, pay down debt, build an emergency fund, save for a down payment, or…
5. Use those proceeds to maximize the next round of ESPP contributions.
One way to use those proceeds is to help with maxing out the next round of contributions.
While you can’t make direct contributions outside of your paycheck, you could certainly put your proceeds into an account that you draw upon in order to make up the difference in net pay that results from increasing your ESPP contributions.
For example, let’s say that you receive $6,000 in ESPP proceeds. You could put that money into a savings account, increase your ESPP contributions by $500 per month, and simply take $500 out of your savings account each month to make up the difference. Your monthly budget would stay the same even with your ESPP contributions increased.
Repeating this process, again and again, can create a self-perpetuating stream of contributions and proceeds that allows you to keep earning free returns without impacting your ability to pay bills and live the rest of your life.
Make the Most of Your ESPP
Used correctly, ESPPs are an almost risk-free way to earn a guaranteed return. That money can then be used for any number of goals, from saving for retirement, to paying off debt, to buying a house, to paying for college, to traveling the world, or anything else you’d like to do.
The views of the author of this article do not necessarily represent the views of Gradifi. We make no claims, promises or guarantees about the accuracy, completeness, or adequacy of the information contained here. Readers should consult their own attorneys or other tax or financial advisors to understand the tax, financial and legal consequences of any strategies mentioned in this article.