How To Get The Most From Your Employee Stock Purchase Plan

Wonderful but often overlooked, an Employee Stock Purchase Plan (ESPP) can be a great way to grow your net worth. However, there are a few rules to learn in order to maximize your savings. Here’s how to get the most from your Employee Stock Purchase Plan.

What Is An Employee Stock Purchase Plan?

An Employee Stock Purchase Plan (ESPP) is simply a benefit plan that allows employees to purchase shares of the company stock – at a discount – using payroll deductions. Each pay period, money is taken from a participant’s paycheck and held in escrow where it is then used to periodically purchase shares of stock.

The Two Types of ESPP

Knowing your type of plan can help you pay less in taxes. ESPPs can be either qualified or non-qualified plans. A qualified plan is one that abides by all of the rules of Section 423 of the Internal Revenue Code. So, if your plan refers to “423(b)” in some form, then you know it’s a qualified plan.

Qualified Employee Stock Purchase Plans feature special tax opportunities, but of course, they also come with plenty of rules. Some of which are:

  • The ESPP is only available to W-2 employees,
  • The plan must be available to all employees, although new employees may be subject to a vesting period,
  • There’s a $25,000 per year limit on stock purchases, and
  • Discounts on stock purchases can’t be greater than 15%.

Non-qualified Employee Stock Purchase Plans have none of the rules and restrictions of their qualified cousins, however, they don’t get the favorable tax treatment that comes with abiding by Section 423(b).

ESPP Timing: Offering and Purchasing Periods

There’s a term that you should be familiar with when you enroll in your ESPP: offering period. The offering period is the defined period of time during which your payroll deductions are accumulated. At certain intervals during the offering period, the accumulated funds are used to purchase shares of stock.

While it’s possible to have offering periods of differing lengths, most Employer Stock Purchase Plans use six- or twelve-month intervals. You can choose to enroll or unenroll in the plan for a given offering period. So, if you miss enrollment, you’ll have to wait until the next offering period.

The purchasing period (or exercise period) is another term specific to ESPPs. During each offering period, there can be multiple purchase dates. For example, let’s suppose your company’s ESPP offering period is 12 months and the purchasing period is 6 months. Therefore, the plan makes stock purchases twice a year after accumulating funds for 6 months.

ESPP Discounts: The Real Employee Benefit

Although not required, the vast majority of Employee Stock Purchase Plans offer a 10% or 15% discount on the purchase of company shares. This is obviously a great incentive for employees who participate.

However, stock prices can fluctuate quite a bit over a six-month purchasing period. Which price is discounted? Most plans have a “lookback period” and allows the plan to purchase shares at the lower of two prices:

  1. The closing price at the end of the purchase period, or
  2. The closing price at the beginning of the purchase period.

If the stock’s price has risen over the purchasing period, this could result in an even deeper discount for anyone participating in the plan.

Taxes: Where Qualified ESPPs Can Shine

If you’re participating in a qualified Employee Stock Purchase Plan, you have two options when it comes to selling your company stock: a “qualifying disposition”, and a “non-qualifying disposition”.

Whenever you sell your ESPP shares, the 10% or 15% discount will be taxed in the same manner as your take-home pay, ordinary income. However, in a qualifying disposition sale, any additional gains would be taxed as capital gains. This is wonderful since capital gains tax rates are much lower than ordinary income tax rates.

In a non-qualifying disposition sale, both the discount and any additional gains are taxed at ordinary income rates. So, there’s plenty of motivation to save money on taxes by ensuring your stock sales are qualifying dispositions.

What makes a qualifying disposition? Two factors:

  1. You hold the shares for at least one year after their purchase date, and
  2. You hold the shares for at least two years after its offering date.

When you log into your company’s ESPP, most plans will show a distinction between your qualified shares and your shares that are subject to disqualifying disposition.

How To Get The Most From Your Employee Stock Purchase Plan

In order to get the most from your Employee Stock Purchase Plan, your contributions need to be maximized, but within the framework of your overall savings strategy. Be sure to prioritize any employer matching in your 401(k) or deferred compensation plans first. Only after that should you turn your attention to your ESPP.

As a reminder, having too much invested in your employer’s stock can be risky. If you’re looking for a cautionary tale, look no further than Enron. By limiting your total employer stock holdings to no more than 10% of your total portfolio, you reduce the risks associated with having a concentrated position.

It’s therefore important to create a plan to sell your ESPP shares as soon as they can be sold in a qualifying disposition. From there, it’s great practice to reinvest the proceeds into your diversified investment portfolio. Having a non-retirement brokerage account is an important step in toward preparing for retirement.

If you’d like help maximizing your Employee Stock Purchase Plan savings, then click here to set up a quick, complimentary introduction call to see if Prana Wealth is a good fit. We do still have the capacity to take on new clients.

As a fee-only financial advisor in Atlanta, we can (and do) work virtually with clients all across the U.S. and we’re here to help you when you’re ready.

The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.
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