Participating in your employee stock purchase plan (ESPP) can be a smart way to invest your money and build wealth. An ESPP allows you to use after-tax income to buy your company’s shares at a discount, typically up to 15% on the market price.
As with any investment, there are benefits and risks to weigh before you decide whether you should contribute to an ESPP. Let’s walk through the pros and cons of participating in an ESPP, and how to factor them into your decision.
The Benefits (or Pros) of Contributing to an ESPP
- Discounts on Company Stock
An ESPP allows you, an employee of a publicly traded company, to buy shares of that company at a discounted rate unavailable to the general investor. You contribute a percentage of your after-tax money from each paycheck for a set time, say six months (the exact period depends on your company plan). At the end of that period, known as the ‘offering period,’ your contributions are used to purchase company stock. Under most plans, you can contribute between 1% and 15% of each paycheck.
The IRS caps the total stock value an employee can purchase using an ESPP to $25,000 in a calendar year.
- Potential for High Returns
Contributing to an ESPP allows you to purchase discounted company shares and sell them at market price, using the cash to meet your financial goals. There are two ways to potentially profit from participating in an ESPP.
At the end of the offering period, you can sell the shares immediately to gain the discount value. You miss out on any additional profits (or losses) should the share price go up (or down). Alternatively, you can hold on to your shares and sell them when the market is more favorable. There’s no guarantee the price will go up, of course, so your shares are subject to market volatility.
Similar to a 401(k), it may not always be practical for you to max out your contribution. The amount you put into an ESPP affects your take-home pay and your cash flow.
That’s where Benny comes in. Benny helps you max out your ESPP contribution by giving you an equal amount of cash to top up your take-home pay. For example, if you’re contributing $350 per paycheck to your ESPP, Benny will deposit $350 in your bank account before your pay date each paycheck so that your take-home pay remains the same. You can then max out your investment.
When the offering period ends, you can sell your shares at market price and reap the discount as gains.
- Tax Benefits
There are two types of ESPPs – qualified and nonqualified. Qualified plans follow IRS regulations and carry the following tax advantages:
- The market price discount you receive is only considered taxable income once you sell the shares.
- Normally you pay ordinary income taxes on the gains from selling stock. Your plan may have restrictions on when you can sell, known as a ‘holding period’. If you meet the IRS’s conditions by holding onto the stock for a year as well as for two years after the grant date and then sell, you pay a lower capital gains tax rate.
Nonqualified plans do not follow IRS regulations and do not have the same tax considerations. This article focuses on qualified plans. Check with your company for details about nonqualified plans or reach out to Benny for help understanding how your plan works.
The Risks Involved/Cons of in Contributing to an ESPP
- Market Volatility and Company Performance
Note that even in a down market, the value of your stock purchase remains protected during the offering period, because the stock price is not set until the end of the period. Some employers also offer a ‘lookback provision’ for additional discounts on the stock price. A lookback provision means the purchase price for calculating the discount is set either at the beginning of the offering period or at the end of the purchase period, whichever is lower. If the stock price has gone up during your offering period, this can help increase your benefit.
For example: Let’s say that during the six-month offering period, you’ve contributed a total of $4,500 to your ESPP and the stock price is $100. The discount offered by your company plan is 15%, which means you get to buy shares for $85 per share. You receive 4,500/85 = 53 shares at the end of the offering period worth $5,300 (53*100).
While your contributions are accumulating, say the share price for your company increases from $100 to $200.
- In a standard plan (no lookback), you would get 15% off the $200, or $170/share. Your $4,500 would buy you 26.5 shares worth $5,300.
- In a lookback plan, you would get 15% off the $100, or $85/share. Your $4,500 would buy you 53 shares worth $10,600.
While your contributions are accumulating, say the share price for your company decreases from $100 to $50.
- In a standard plan (no lookback), you would get 15% off the $50, or $42.50/share. Your $4,500 contribution would buy you ~106 shares worth $5,300.
- In a lookback plan, it would be the same, you would get 15% off the $50, or $42.50/share. Your $4,500 would buy you ~106 shares worth $5,300.
So as you can see, your return remains if the stock price remains flat or even decreases during the period.
How to weigh this factor: Identify the level of risk you’re comfortable with – your risk tolerance – when you’re deciding how much to contribute to your ESPP. If you sell your shares right away, at the end of the offering period, that protects your discount. You still have to pay ordinary income taxes on the gains.
- Concentration Risk
Buying a lot of your employer’s stock essentially concentrates your investments in one company. This is typically not a good investment strategy because it’s akin to putting all your eggs in one basket. Ideally, an ESPP should be part of your overall investment strategy, including investing in index funds and retirement funds.
How to weigh this factor: It may be helpful to think of an ESPP as a tool to save up for short-term goals, such as a down payment for a house or a new car. If you regularly contribute to the ESPP during the offering period and sell shares immediately, you automatically reduce your concentration risk. If you hold onto them, your tax bill may be lower but that may be offset by a drop in value if the stock price falls.
When You Should Consider Contributing to an ESPP
- Your Company is Stable and Profitable
This might seem like a no-brainer, but it’s worth saying. As an employee, you are offered an ESPP as a benefit. The minimum you stand to gain is the discount percentage on your stock purchase. If there is a lookback provision, you may get a bigger benefit. These are all good reasons to contribute to your ESPP.
Note: Some company employees are not eligible to participate in an ESPP, such as individuals who own more than 5% of the company’s voting stock. Read your company’s plan rules to find out if you are eligible.
- You Can Afford to Take a Certain Level of Risk
Once you’ve figured out your risk tolerance, you can decide how much to put into your ESPP. Your financial goals play a big part in this decision. If you want to save up money for a short-term goal and are ok with a temporary hit to your cash flow during the offering period, participating in an ESPP is a solid option.
Benny helps make the decision easier because you don’t need to compromise on how much to contribute. You can max out your paycheck contributions without affecting your cash flow. At the end of the offering period, you can sell your shares and have cash in hand for your goal.
When Not to Contribute to an ESPP
- Debt and Financial Obligations are High
If you’re already having a hard time staying on top of other debts, such as student loans and credit cards, it may not be a good idea to invest in an ESPP. Generally speaking, covering your financial bases first is advisable, such as making a budget, saving for emergencies and retirement.
Isaac Pressley, President and CEO of Cordant Wealth Partners and a certified financial planner, recommends first asking yourself how you are going to pay for the ESPP, how that will affect your other financial contributions, and what you are going to use the ESPP money for.
Benny can help you understand how much to realistically contribute to your ESPP. By giving you money to ensure your cash flow is not affected, you can still participate in the plan and get the benefit of an ESPP discount while you address your other financial obligations.
- Your Plan Requires a Holding Period
A handful of ESPPs require employees to hold onto shares for a specific period of time, which could range from six months to two years. If this is the case, you lose out on the benefit of selling your stock immediately. You won’t have access to cash at the end of the offering period, effectively tying your money up. You’re also subject to market volatility while you hold onto the stock. These are good reasons to pass on contributing to your ESPP.
Again, your risk tolerance plays a part in this decision. If you are comfortable owning so much company stock for a long period (concentrating your money in one stock) and your job is stable, you can still consider participating in the ESPP.
Making the decision to contribute to your ESPP depends on the plan your company offers, your risk tolerance, and your personal goals and obligations. Use Benny’s calculator to see how much you can potentially earn by contributing to your ESPP plan.