A good employee stock purchase plan (ESPP) is something that many consider being a no-brainer when it comes to deciding if you should take advantage or not. Contributing to an ESPP is often accomplished through convenient payroll deductions, and many participants benefit from features like lookback provisions or discounts to the purchase price.
At first glance, participating in an ESPP that’s available to you can seem like the obvious “right” choice. But there are other factors that you might want to consider before deciding.
For example, how will a reduced paycheck impact your household cash flow? You may also want to explore the investment risk inherent in purchasing shares of your company’s stock, and if you can truly afford to take on (or want to take on) additional concentration risk. Then, of course, there are the tax planning considerations to keep in mind.
Your plan document can tell you how your employee stock purchase plan works — but there are still details to dig into before you can understand if using your ESPP is the best choice for you. Here’s what to think about before getting started.
1 – How Will Participation in Your ESPP Impact Your Cash Flow?
If you choose to participate in an employee stock purchase plan, one of the first decisions to make is what percentage of your salary you’ll contribute to the ESPP.
ESPPs are usually set up so that you can contribute up to a maximum percentage of salary, like 10 to 15 percent. Some companies may also allow you to contribute a fixed amount. You can contribute at your chosen contribution rate until you reach the maximum allowable annual limit of $25,000 per year (for a qualified plan).
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In either case, remember that contributions to a plan come from your paycheck — which means the more you contribute, the less take-home pay you have.
Using an example to illustrate how your contribution may impact your take-home pay, let’s assume that you make $150,000 per year and elect to contribute 15% of your pay to the ESPP, or $22,500.
Unlike pre-tax contributions to a 401(k), contributions to an ESPP are made with after-tax dollars. This means a “true” reduction of $22,500 per year of cash flow from your paycheck. If you get paid 26 times per year, that means taking home about $865 less per paycheck.
Before contributing to an ESPP, you may want to consider how your contribution will impact your take-home paycheck, and how you plan to accommodate for the reduced cash flow at home.
2 – If Cash Flow Is an Issue, Can You Limit It to a One-Time Problem?
If a reduction to your take-home pay doesn’t work for you, it might seem like an ESPP is out of the question — but if the plan offers benefits like a lookback provision and discount on company stock, it might be too good of an opportunity to pass up.
So how do you manage the cash flow problem with the opportunity presented by the plan? Depending on how you manage the ESPP, you could turn a reduction in every paycheck into a one pay period problem.
Continuing with our example from above where you contribute $865 per paycheck to the plan, let’s say your company ESPP has a 6-month purchase period. At the end of that period, your contributions are used to purchase shares of stock.
In total, you’d contribute $11,235 to the plan to buy shares. If your ESPP offers a discount, you may be able to immediately sell your shares at market value and lock in a profit equal to the discount you received when buying them.
You can use these proceeds to supplement your continued reduction of salary due to your ongoing participation in the ESPP. Doing this after every purchase period can mean a hit to your cash flow from reduced take-home pay might reduce take-home pay a one-time problem to plan around.
Moving forward, you can manage cash flow via an immediate sale of stock and still benefit from the potential benefit of a purchase price discount and lookback provision.
3 – What Is Your Strategy to Keep or Sell Your ESPP Shares?
Participating in an ESPP means buying shares of company stock. Before you sign up, you might want to develop a strategy for keeping and holding your shares — or selling them.
The decision to keep your ESPP shares likely needs to include a detailed discussion of investment risk, concentration risk, cash flow, income tax, and other needs. It may also include a conversation regarding your personal opinion of the future value of the stock.
If you don’t set a plan for what to do with the shares you buy, you may default to taking no action. That could lead to an increased position in company stock, which might not align with your overall investment plan.
Concentration in a single stock might not be a problem if you have a good plan for holding shares, or you happen to benefit from an increasing stock price. But accumulating shares could leave you overexposed to company stock and open to the risk of a falling stock price wiping out significant wealth.
4 – How Does Income Tax Impact Your Plans to Purchase, Hold, and Sell Shares in an ESPP?
If you participate in an ESPP, you’ll likely hear the terms qualifying disposition and disqualifying disposition. These terms speak to holding period requirements for your ESPP shares that impact how and when the proceeds of your sale will be taxed.
A qualifying disposition is a final sale of ESPP that meets the following 2 requirements:
- The final sale of your shares occurs at least 2 years from the grant date, AND
- The final sale of your shares occurs at least 1 year from the purchase date.
Generally speaking, if you meet the qualifying standard and profit from the transaction, the discount from the purchase price received (if any) will be taxed as ordinary income, and all other proceeds will be taxed as a long-term capital gain.
Anything that does not meet this standard is a disqualifying disposition of the stock. With a disqualifying disposition, the gain between the actual purchase price of the stock and the purchase date price of the stock is taxed as ordinary income, and the remainder is taxed as a capital gain (or loss).
While it may seem like it’s easy to argue that better tax treatment is always a better outcome if all else is equal, the reality is that rarely is all else perfectly equal.
To obtain this tax treatment, you must hold your shares for at least 1 year past the purchase date and two years from the grant date. During this requisite holding period, the stock price may fluctuate, and you may end up with less after-tax (even if at a better tax rate) than had you sold the stock immediately after the shares were purchased.
You need to take this possibility into account when considering the best strategy to use for managing shares you buy through an ESPP.
Moving Forward with Your ESPP
In addition to understanding how you ESPP works, understanding key ESPP terms, and knowing what benefits your plan offers in terms of a discount and a lookback provision, you may also want to understand how participating may impact your cash flow, your financial plan, and your risk tolerance or ability to manage concentration risk.
Ultimately, your ESPP might be a great tool to use — but make sure you have a plan for how you’ll manage the opportunity both now and in the future.
This material is intended for informational/educational purposes only and should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product. Hypothetical examples contained herein are for illustrative purposes only and do not reflect, nor attempt to predict, actual results of any investment. The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation. Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.
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