If you work at a company with an Employee Stock Purchase Plan (ESPP), you may be wondering if it’s a good investment. You might have questions about how it’s taxed and whether to even enroll in it. Our firm is experienced in helping scientists, engineers and executives from companies like Illumina (ILMN), Northrop Grumman (NOC) and Pfizer (PFE) to make the most of their ESPP plans, and in order to help, we’ve prepared this brief primer to help explain the basics of ESPP plans and to describe an example of one advanced strategy that we like.
Before you decide how best to utilize your ESPP, it’s important to understand how an ESPP is generally taxed; ESPP shares are post-tax. In other words, your employer stock is purchased with money on which you’ve already paid taxes, so taxes are only due when the stock in the ESPP is sold.
If you purchase shares and immediately sell them, you’ll pay income taxes on the 15% discount, which is considered compensation by your employer. If you hold the shares after your purchase and they appreciate in value, you’ll likely pay capital gains taxes in addition to income tax on the discount. In order to qualify for favorable long-term capital gains taxation, you’ll have to hold your shares for more than two years after the start of the offering period and more than one year after your purchase date.
Purchasing stock at a discount is certainly a valuable tool for accumulating wealth. An ESPP plan with a 15% discount effectively guarantees an immediate 17.6% return on investment. (To understand this return, consider a stock trading at $10 per share. An employee with access to an ESPP program with a 15% discount is able to purchase shares at $8.50. He or she can immediately sell shares for $10. This sale results in an immediate guaranteed profit of $1.50 per share on an investment of $8.50 per share, or 17.6%.)
Of course, as with any stock, the value of ESPP shares can drop or even disappear altogether. A 15% decline in the stock price can easily (and frequently does) wipe out the value received for participating in the plan. This risk of loss is especially important to remember when it comes to investing in your employer’s stock-- having a large portion of your nest egg in addition to your salary both tied to the performance of one company creates undue risk. To avoid that, our firm uses sophisticated proprietary software to stress test clients’ financial plans so that we know how much employer stock they can afford to own without potentially jeopardizing their plans.
It’s clearly best to consider an ESPP contribution strategy in the context of one’s overall financial plan, and everybody’s plan is different. That being said, we do see certain patterns among highly compensated employees at firms offering ESPP programs. Many may also be awarded stock options and restricted stock as part of their compensation. As a result, if their company has done well, they may actually own too much of their company stock to maintain proper diversification and balance in their portfolio. Additional purchases of employer stock would only serve to further concentrate their investments and create unnecessary risks in the event the stock failed to perform.
One strategy we like for these highly compensated clients involves a cycle of maximum ESPP contributions, simultaneous sales of high-basis shares, and immediate investment of proceeds in tax-advantaged accounts. The investor obtains the guaranteed 17.6% immediate return on investment due to the ESPP discount. He or she sells an equal amount of previously held company stock in tandem with each ESPP purchase. The investor essentially replaces his or her employer stock holdings with stock purchased at a discount.
Moreover, recently awarded shares from restricted stock units (RSU’s) are often a great source of shares to sell upon each ESPP purchase. Recently vested restricted stock units are likely to have a high cost basis, and they don’t generate the additional income taxation associated with sales of ESPP shares. Proceeds from stock sales are then invested in more tax-advantaged accounts in order to satisfy retirement savings, which might have otherwise been funded from a client’s earnings. If the usual savings strategies, such as normal 401(k) contributions, have been maximized already, proceeds from stock sales can be deployed elsewhere. “Mega Backdoor Roth” savings, Healthcare Savings Accounts, or Deferred Compensation plans are common choices; these can provide either an additional income tax deduction, tax-deferred growth, tax-free growth, or a combination of benefits. The net result of this type of transaction can be an immediate 17.6% return on investment, deferral of income taxes on the ESPP discount and no added investment risk.
The bottom line for employees at companies with an ESPP is that there are lots of moving parts that make them attractive. However, you ultimately need to honestly assess your company’s prospects as any investor would-- an ESPP at Carnival Cruise Lines (CCL) or Boeing (BA) this year might not have been altogether helpful, so be sure to look at your ESPP as just one of the tools in your overall financial strategy. …And remember that just because you own a nine-pound sledgehammer doesn’t mean you have to use it for every project.
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