If you happen to work for a company that offers an Employee Stock Purchase Program (ESPP), then just like a 401(k) match, your employer is basically offering you free money and you should do whatever you can do to max out your participation in the program.
What Is An ESPP – Employee Stock Purchase Program?
An Employee Stock Purchase Program (ESPP for short) is a way for you to purchase company stock at a discounted rate. ESPPs differ from company to company, so let me be clear that I’m writing about my own experience from the two ESPPs that I’ve been able to participate in, which happen to have been set up the exact same way.
Both programs worked like this: employees have the option to buy discounted company shares twice per year. The two purchase dates come at the end of what’s called an Offering Period, each one lasting six months, during which contributions to the program are automatically deducted from your paycheck, if you have enrolled in the program. All of your deductions are pooled together during the Offering Period and at the end of it, your company takes your contribution and purchases company stock, usually at a discounted price, and deposits the stock into your brokerage account, where you can do whatever you want with it.
How Much Is The Discount?
In a good ESPP you can actually combine two types of discounts:
- A percentage off the price of the stock
- A Look Back purchase option
The percentage off is straight forward. The discount has been 15% discount in the both programs that I’ve had the opportunity to participate in. From what I can tell a 15% discount seems to be pretty standard. A discount is great because it means you get to purchase your company stock for 15% cheaper than anybody else can.
If your company’s ESPP does not offer a discount, then I’d pass on participation. At that point you’re just pooling your cash to buy company stock at current market rates.
Thanks, but no thanks. Take that money and instead invest it into an index fund.
ESPP Look Back Discount
The other type of discount is what’s called a Look Back. This means that the purchase price of your stock is the lowest price from the first and last day of your offering period. Confused? Here’s an example to clarify. Hopefully.
Say your company’s offering period runs from May 15th to November 15th. On May 15th your company stock price is at $28.00 and on November 15th the price is at $30.00. A Look Back means that you get to buy the stock for $28.00 — $2 bucks lower than the current market price of $30. Nice, right
“But wait, there’s more!” You not only get to purchase your stock for $2 bucks less than the current market price, but you also get a 15% discount ON TOP OF the Look Back pricing, meaning your actual purchase price would be $23.80 ($28 Look Back price minus a 15% discount).
So, the current price of the stock is $30.00, but you get to buy it for $23.80 – no brainer, right
But what if your company stock has tanked during the six month Offering Period? Don’t sweat it – you still get a 15% discount on the Look Back price and can sell for an immediate profit. That assumes that your ESPP allows you to sell immediately. Some programs make you sit on the stock for a certain amount of time before you can sell, if that’s the case with your employer’s ESPP then you’ll want to take a closer look before deciding to participate.
Watching your newly purchased stock take a nose dive while you’re in a waiting period wouldn’t be a good feeling. If you have to sit on your ESPP stock for an extended period of time, then you run the risk of losing all the gains you got by purchasing at a discounted rate.
How Much Can You Contribute To The ESPP?
Typically employees can contribute somewhere between 1 and 30% of their eligible paycheck to the ESPP. I’ve always been able to contribute up to 15%, so a cap of 30% would be amazeballs!
Eligible income is after-tax earnings, including base pay, overtime, bonuses, commission, monthly incentives, and PTO pay.
Bringing It All Together
Let’s assume that you earn the 2014 average national wage of $46,500 per year and pay 15% in taxes. This leaves you with $39,525 of Eligible Income that you can pull from to contribute to your ESPP.
Let’s further assume that you’re a rock star and max out participation at 15% of your eligible, after-tax income; that would be $228.03 per check (this assumes 26 pay periods per year; some employers have 24 pay periods, but either way, you make and contribute the same amount of money).
$228.03 per check, multiplied by 13 paychecks in your Offering Period equals a pool of $2,964.38 with which you get to purchase stock in your ESPP.
Using our same stock price numbers of $28.00 and $30.00 that we used above, let’s assume that the current price of your company stock is $30.00. But because of your Look Back option, the price you get to buy at is only $28.00, minus a 15% discount, for a total sales price of $23.80.
At those numbers, your pool of $2,964.38 will buy you 125 shares of company stock (rounding up).
Remember that we said a good ESPP program will let you sell your stock immediately? Well you now have the ability to sell your 125 shares of stock at $30 per share (current market rate) for a total of $3,750 dollars.
Congratulations! You just turned $2,964.38 into $3,750 for doing nothing other than seizing the opportunity.
“Here’s your free money, have a nice day and let’s do this again in six months.”
What About Taxes?
Yup, taxes are a thing that must be dealt with. Generally speaking…..
- Because you purchased your ESPP stock with after-tax dollars you’ll only have a tax implication when you sell your stock. The situation is different depending on whether you sell your stock before or after 18-24 months from the purchase date.
- If you sell your ESPP stock within 18-24 months of the purchase date then you get to pay taxes on your gains. Additionally, the discount you received on the purchase price will be reported on your W2 as ordinary income; this is called a disqualifying position. Although the income gets reported, your company won’t hold out any income taxes on the discounted amount, nor is FICA paid on the gain.
- If you are willing to sit on your stock for 18-24 months you can benefit from favorable tax treatment on the sale, known as a qualifying position. Basically, your profit from the sale is considered a long term capital gain and benefits from a lower tax rate. The discount you received on the original purchase price is considered compensation income and is taxed at a regular rate as well.
If you’re not in a position right now where you can afford to participate in your company’s ESPP, get yourself in a position to participate ASAP because, just like your employer’s 401(k) match, this is like free money. All you need to do is reach out and take it.
This post was first published on 04/28/2016 on Get Rich Quick’ish.