Should You Participate in Your Employer Stock Purchase Plan (ESPP)?

Employee Stock Purchase Plans (ESPPs) can be a great tool for building wealth, if you’re disciplined enough to use it optimally. However, used improperly, these plans have the potential to wreak havoc on your financial planning. 

If you’re considering participating in your company’s ESPP, it’s important to carefully review the relevant information, and develop a strategy in advance to help minimize the risks involved. 

What is an ESPP?

In general, an Employee Stock Purchase Plan is a company benefit that allows you to purchase shares of your employer’s stock, usually at a discounted price. 

Your contributions are regularly deducted from your paycheck and will typically accrue in a separate account until your employer’s stock purchase date. The frequency of stock purchase dates is generally dictated by your employer. The discount rate and the frequency of purchase dates are unique to each employer, so you’ll want to read the plan documents for this info.

There are two basic types of ESPPs: Qualified ESPPs and Non-Qualified ESPPs. It’s important to know which type your company offers so you can optimize your strategy.

The Difference Between Qualified and Non-Qualified ESPP

Qualified and non-qualified simply refer to the plan’s compliance with IRS guidelines. The bulk of these differences are primarily a concern for your employer. Since you’re likely only interested in how these differences affect you personally, we won’t go into the boring details.

For you (the employee), the primary difference between qualified and non-qualified ESPP is the tax treatment on the stock purchase date. The discount you receive when purchasing stock through an ESPP is considered taxable income and will ALWAYS be taxed as ordinary income. The difference is when that tax liability is due.

Qualified ESPPs offer tax deferral, meaning the taxes aren’t due until you sell the stock. Non-qualified plans do not offer this feature, so you will have a tax liability once the stock is purchased.

Once the stock is purchased, it is generally treated as ordinary stock ownership in terms of holding period requirements and capital gains or losses. 

Non-Qualified ESPP

This one is less common and more straight-forward. Once the stock is purchased, the difference between the fair market value and your discounted purchase price will be taxed as ordinary income. The fair market value on the date of purchase becomes your new cost basis, and regular holding period and capital gains treatment applies.

Qualified ESPP

These can be rather complex and tedious. The full details are beyond the intended scope of this post, but I’ll provide you with a simplified and generalized breakdown. Treatment is based on holding period and is classified as either a Qualifying Disposition or Disqualifying Disposition.

Qualifying Disposition

To be considered qualifying, the employer stock must be held for at least two years from the offering date and one year from the actual purchase date. Once sold, the discount received is taxed as ordinary income, but any gain received is taxed as a long-term capital gain.

It’s important to note how your employer determines the discount, as this will impact your ordinary income tax liability.

Disqualifying Disposition

Any sale that does not meet the holding period requirements to be a qualifying disposition is a disqualifying disposition. The greater of the actual discount received or the difference between the fair market value on the purchase date and the purchase price will be treated as ordinary income. Any other gain will be treated as a short-term capital gain.

Note: Some plans will offer a discount based on the lower of the current stock price, or a price from the start date of the ESPP period. This can create a dramatic difference in the discount received versus the difference between the fair market value and the actual purchase price.

Is ESPP Worth It?

As with virtually everything in financial planning, the answer is…. It depends. 

Each ESPP plan is unique, and each individual’s financial and personal situation is unique. So, it’s impossible for us to tell you whether or not it’s worth it without first reviewing everything as this is a key part of our proven process for financial planning.

General Examples of When ESPP is beneficial

If your company offers a large discount (generally up to 15%), it may be worth participating. If you sell the shares immediately after they’re purchased, you may be able to realize an immediate 17.64% return. Granted this will be fully taxable at your marginal tax rate, but even if you’re in the 37% tax bracket, that’s still over an 11% return.

This is generally the path we recommend to our clients, but again, each financial planning situation is unique. Many companies that offer ESPP also offer other stock incentives, and having too much exposure to your company’s stock can be a risky position.

If you believe your company has a very strong future outlook, ESPP can be a great way to capitalize on this. Not only can you buy the shares at a discount, but you also get favorable tax treatment on appreciation if you meet the above-mentioned holding periods. The trick here is to not be too over-concentrated in your employer stock. If you have RSUs or other equity compensation, you’ll want to factor those into the equation.

General Examples of When ESPP May Not be a Good Fit

Contrary to the examples above, if your employer only offers a nominal discount, participating in the ESPP may not be the best option, especially for those who are in higher tax brackets. However, if your strategy is to buy-and-hold, this could still be beneficial, assuming your company’s stock performs well over time.

If your employer offers other forms of equity compensation or incentives, such as profit-share 401(k) contributions of employer stock, RSUs, ISOs, NSOs, etc., then you’ll want to carefully consider the risks involved with having more exposure to your employer’s stock through ESPP. This could potentially lead to having a substantial amount of your net worth tied to your employer. While this may seem great when the stock is on the rise, nothing lasts forever, and I doubt you’d want to be holding so much company stock when/if the company takes a turn for the worst. 

Your self-discipline and emotions can have a dramatic impact on the effectiveness of your ESPP also. People are generally loss-averse, so they hate to see their holdings decline in value. However, it’s also easy to get emotionally attached to your shares if they have been increasing in value, making it difficult for some to sell at the opportune moment. If you’re unable or unwilling to sell shares when needed, ESPP may not be a good choice for you as you’ll likely end up with a heavily concentrated position of employer stock in your portfolio.

Our Recommendation

There’s no one-size-fits-all answer as to whether or not you should participate in your employer’s ESPP. 

If the available discount is attractive and you’re willing and able to strategically sell the shares after they’re purchased, then we generally recommend participating at a modest level to get the immediate return. If you don’t have other stock incentives from your company, then it’s perfectly acceptable to hold onto some shares for future growth potential. Just don’t overdo it and make sure that you stay properly aligned with your financial plan. 

If you do participate, we generally recommend selling your shares as soon as possible. Yes, this will cause an increase in your current tax liability, but it will reduce your risk of a loss if the company’s outlook changes before you’ve met the holding period requirements. Make sure to set some of your profits aside in a high-yield savings account, or make estimated tax payments to tackle the future tax bill.

For those with a low discount rate and/or high tax bracket, it may be a better idea to boost contributions to your qualified retirement plan to lower your tax liability and provide more diversification. If you’re already making the maximum contributions to your retirement account, there are other opportunities we can help you evaluate to optimize your situation.

We work with a variety of clients with access to their employer’s ESPP, and our recommendations are generally different for each one of them. Some participate and sell immediately, some buy and hold, some do a combination, and some don’t participate at all. It’s all about finding the best path toward helping you achieve your objectives, while keeping you within your comfort zone.

If you’d like us to help you analyze your available employer benefits, and optimize them for your specific situation and goals, we encourage you to connect with us. You can scroll down to schedule a free, no obligation Introductory Conversation to get to know us better to see if we’re a good fit. If you’re not ready yet, that’s fine too. We’ll still be here when you are.