What Is an ESPP Plan, and Should You Contribute?
Employee benefits come in all shapes and sizes. Your company might offer an Employee Stock Purchase Plan (ESPP), which can be a nice perk. It lets you buy company stock at a discount—and turn a quick profit if you immediately sell your shares. They’re pretty commonplace; nearly half of S&P 500 companies offer one, according to Human Capital Solutions.
Like anything else, there are pros and cons to contributing to an ESPP. Let’s break down the details so you can determine if it gels with your overall wealth management plan.
The Basics of an ESPP
The main draw of participating in an ESPP is that you can purchase company stock at a price that’s below market value. Rates can vary, but most companies offer discounts to the tune of 5% to 15% off. That can work out to significant savings if you’re scooping up a large chunk of shares, especially if you sell them shortly after.
Contributions to an ESPP are made via automatic payroll deductions, making it easy to participate because you don’t have to go out of your way to kick into the plan. An enrollment period usually rolls around every six months. During this time, you’ll clarify how much you’d like to contribute every pay cycle. These contributions are then funneled directly from your paychecks into an ESPP account until a predetermined purchase date. At that point, these set-aside funds are used to purchase discounted company stock shares.
Important ESPP Dates
The timeframe in between the enrollment period and purchase date is known as the lookback period—and it’s important because it could determine the size of your discount. We all know that stock prices fluctuate. It comes with the territory when you’re investing. If the purchase date rolls around and the stock price has gone down since the enrollment period, you’ll simply buy shares at the lower price.
But if shares have increased since you opted into the plan, the lookback feature allows you to buy at the original lower price. It’s an attractive benefit that will likely position you to net even better returns when you sell your shares. Just keep in mind that not all ESPPs are structured this way. Be sure to read the fine print before enrolling.
ESPP plans come in all shapes and sizes so we highly recommend attending info sessions provided by your company and reading through any materials so you can get a solid understanding of the specific details of your plan. Sometimes plans will require you to hold the stock for a whole year after the purchase date before you can sell, and other plans won’t have a lookback feature for you to take advantage of a lower purchase price.
ESPP Contribution Limits
The IRS has guardrails in place when it comes to annual purchasing limits. Participants can buy up to $25,000 worth of stock each year using an ESPP. The final calculation is based on your discount and the stock price at the beginning of the enrollment period. The math can be a little tricky, but stay with us here.
Let’s say the stock price at the start of the enrollment period was $12, but went up to $14 on the purchase date. If there’s a lookback period allowing you to buy at the original price, this is how the numbers would shake out assuming your company offers a 15% discount:
15% off $12 puts your purchase price at $10.20 per share
$25,000 (maximum purchase amount) divided by $12 (stock price at the beginning of enrollment period) = 2,083 maximum shares you can purchase
2,083 multiplied by 10.20% = $21,247 maximum purchase for the year
How Are ESPPs Taxed?
When you sell stock for more than you paid for it, you’ll likely have to pay capital gains tax on the profit. (Your tax liability will depend on your income and how long you held the stock.) When it comes to paying taxes on ESPP gains, your timeline is key. If you sell your shares quickly and turn a profit, there will be a gap between your discounted purchase price and the market value when you sell your shares. This difference is taxed as ordinary income, which is typically higher than long-term capital gains tax.
It’s a different story If you hold shares for at least one year from the purchase date and two years from the grant date. In this case, the discounted purchase price is considered taxable income—but gains are taxed at a lower capital gains rate.
While it may be tempting to hold onto company stock long enough to capture that tax break, there’s no way of knowing how its price will fare during that time. If it dips below what you paid for it, you’ll ultimately lose money. This is why most financial experts suggest quick sales when participating in ESPPs.
What It All Means for Your Paycheck
Now for the most important question: What does this all mean for your day-to-day financial life? It’s true that ESPPs can be a great way to grow your wealth. It’s a hands-off form of investing that allows you to profit even if your company stock maintains its current price.
Going all in can make a lot of sense, but you have to remember that contributions are based on your gross income and taken directly from your paycheck. After accounting for all your regular deductions (health insurance, retirement contributions and the like), participating in an ESPP could put a dent in your monthly cash flow. We recommend running the numbers to see if it’s something you can afford without impacting your lifestyle.
You’ll also want to look at your debt load. If you’re up against high-interest balances, you might want to tackle those first. Potential investment returns could be a wash if you have credit card debt with high interest rates.
The Bottom Line
If you’ve got cash on hand to participate in an ESPP, it can be a powerful way to boost your savings and fund both short- and long-term financial goals. Why not snag a built-in 15% discount on publicly traded stock? But we get that it can be a lot to digest. We’re here to help walk you through it and see if participating in your company’s ESPP is the right move for your unique financial situation.