A Guide to Employee Stock Purchase Plans (ESPP): One Path to Building Wealth, Faster.
To hell with waiting until 65 to enjoy your money. You want to build wealth and you want to do it more quickly than your parents did.
Part of building wealth is knowing all the tools available to you. An ESPP plan is one tool in the “wealth building” toolbox you might be completely overlooking.
Time, energy, and money. Throughout life we generally have 2 of the 3. When you’re young you have time and energy but no money, in your middle ages you have money and energy but no time, then as an old person you have time & money, but no energy. This is why our generation wants to build wealth more quickly than previous generations, to be able to enjoy their money while they’re still young and healthy! Screw the idea of waiting until 65 to enjoy your money.
So you want to build wealth too, and you want to do it quickly. You too can build wealth while still “keeping it simple”. Let’s not make it bigger than it needs to be! Today, I share with you one approach to building wealth more quickly. Introducing the ESPP…
What Is An ESPP?
An ESPP, employee stock purchase plan, is a benefit offered by a company that allows it’s employees to purchase their employer’s stock at a discounted price. Not every company offers an ESPP but if yours does (you can check with HR on this) it’s definitely something you should be considering! To buy the stock, employees contribute to their plan via payroll deductions. These deductions build up between the offering date and purchase date. The company will use an employee's accumulated funds at the purchase date to buy stock in the company on behalf of employees who participate in the ESPP.
ESPPs are offered as an incentive to employees. They give employees a way to share in the growth potential of a company's stock and feel more invested (psychologically and financially) in the well being of the company. It aligns your interests with theirs. They also inspire employees to keep working hard so that the stock price moves up.
Advantages of Employee Stock Purchase Plans
ESPPs have a number of advantages for both employers and employees:
Discount to purchase stock: Employees can often purchase stock at a 15% discount from market value. This creates an immediate built in 15% return, a high return over a short amount of time.
Motivates employees: It’s another way employees can receive additional compensation that does not directly come out of the company's pocket.
Promotes money-saving habits: ESPPs help get participants in the habit of regularly saving money from their paycheck. To make it even better, all contributions are exempt from payroll taxes like Medicare and Social Security tax.
Flexibility to Diversify: You can generally sell your shares after the purchase date (some immediately, some after a period of time). You don’t want to be too heavily weighted in any one company’s stock so you can stay diversified.
The "Look back" provision: Allows employees to use the lower closing company share price of either the purchase date or offering date. This can have a positive effect on the amount of gain participants receive. Better to get a 15% discount on a lower stock price than a higher one.
How Do Employee Stock Purchase Plans Work?
ESPP plans generally operate on two key windows of time, an enrollment period and an offering period:
Enrollment Period of the Employee Stock Purchase Plan
ESPPs start with an upfront enrollment period. During this period, you get to decide the percentage of your paycheck you want deducted to buy company stock at a discount. Typically plans may allow you to contribute up to the lower of…. 15% of your salary or $25,000 per year.
ESPP contributions are usually “after-tax” but some plans lets you contribute “pre-tax”. Some ESPP plans have a minimum contribution of 2% of your salary to participate.
Offering Period of the Employee Stock Purchase Plan
Most ESPPs have a 12- or 18-month offering period. The offering period is made up of two or three purchase periods of six months each. Offering periods are divided into shorter purchase periods to maximize the value of the benefit you receive.
After you enroll in your company stock purchase plan, your payroll contributions will accrue. This happens until the last day of each purchase period, when your employer purchases company shares on your behalf using the accumulated funds.
ESPP Plans & Taxes: A Timeline of Potential Tax Impacts
How much tax you pay depends on when you sell the stock purchased in your ESPP. Here’s a timeline to consider:
You contribute money from your paycheck to the ESPP during the offering period. The employer isn’t required to withhold Social security or Medicare tax on the contributions.
The employer then buys stock on your behalf on the purchase date at a pre-determined discount. No tax is due at this time, not until you sell the stock. This leaves more in the account to compound and grow.
You hold the stock for under a year before selling it: Gains in this scenario are considered “compensation” and taxed as such.
You hold the stock for over a year: In this case, any profit you make will be taxed at the lower capital gains rate. This rate is usually lower than in the above situation.
How much of the stock sale price is compensation and how much is capital gain?
That depends on whether your stock sale is a qualifying disposition or a disqualifying disposition.
Disqualifying disposition:
You sold the stock within two years after the offering date or one year or less from the exercise (purchase date).
Your gain in the stock is known as the “bargain element”, it is the difference between the exercise price and the market price on the exercise date.
In this case, your employer will report the “bargain element” as compensation. This means you will have to pay taxes on that as “ordinary income”.
Any additional profit is considered capital gain (short-term if held <1 year or long-term if held >1 year). Short term capital gains are tax at regular tax rates so you save taxes by holding the shares longer. Long term capital gains are taxed at special lower tax rates.
Qualifying disposition:
You sold the stock at least two years after the offering (grant date) and at least one year after the exercise (purchase date).
If so, a portion of the profit (the “bargain element”) is considered compensation income (taxed at regular rates).
The remaining profit is a long-term capital gain (again, taxed at lower rates than compensation income).
Risks to Consider Before Going “All In” on Your ESPP
With all the benefits of an ESPP, you may think, why not go “all in” on the ESPP by contributing the max to it (the lower of 15% of your salary or $25,000 per year)? Well, there are risks to consider:
Investment Diversification: Generally speaking, having more than 5-10% of your overall portfolio in any one stock is not ideal. You want to be diversified across many companies, many industries, many asset classes, and even many countries to be properly diversified. One way to achieve this is through ETFs (exchange traded funds) or Mutual funds which allow you to invest into a basket of companies, countries, and asset classes, so you’re not overly invested in any one stock.
Your Income: This company already provides your income. If they go under then your income would also disappear along with your investments in that company. It’s wise to limit how much impact any one company can have on you should the worst case happen.
Holding Period: ESPP plans can vary between companies. Some may require you to hold the company stock for a certain period of time before selling which impacts how quickly you can diversify out of that company stock.
A Balancing Act: The key with an ESPP is balancing how much to take advantage of that “built in return” without losing proper diversification in the process.
ESPP’s In Summary
If your employer offers one, ESPP’s are a fantastic way to build wealth more quickly and should not be overlooked! They can help you get an immediate return (typically 15%) by buying stock at a discount, help save you money on taxes, and get you in the habit of saving regularly. The key is balance, you don’t want too much of your portfolio in any one company stock and this goes double if your income is ALSO tied to this company.
If you’d like guidance on how to build wealth more quickly,
schedule a free 30 minute call with me here. Guiding young families and professionals to see ALL the different ways they can grow their wealth is my purpose.
San Diego Financial Advisor | Fee-only Fiduciary
Disclosure:
None of the information provided is intended as investment, tax, accounting, mental health, or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement, of any company, security, fund, or other securities or non-securities offering. The information should not be relied upon for purposes of transacting securities or other investments. Your use of the information is at your sole risk. The content is provided ‘as is’ and without warranties, either expressed or implied. Wonder Wealth LLC does not promise or guarantee any income or particular result from your use of the information contained herein.