ESPP: Are Employee Stock Purchase Plans Worth It?

An ESPP, or Employee Stock Purchase Plan, is a benefit some public companies offer to their employees. It allows employees to purchase company stock at a discounted price. Let us tackle the factors which make ESPP a valuable perk and whether or not you should participate.

What Is an Employee Stock Purchasing Plan (ESSP)?

An ESSP allows you to buy your company’s stock at a discounted value, usually around 5-15% of the fair market price.

For example, if your company stock is trading at $100, and the plan discount is 15%, you will receive stocks at $85.

If your company has an ESPP, you can buy stock and potentially sell it for a 15% guaranteed profit immediately. Alternatively, you can keep the stock and sell it at your chosen time. In either case, you can ultimately increase your profit by buying the stock at a discounted rate.

Of course, not every company offers an ESSP. A company must be publicly traded and have a qualified or non-qualified plan to provide an ESSP; even then, only about half of all publicly traded companies make that offer.

The most significant advantage of an ESSP is unquestionably the ability to purchase company stock at a discounted rate.

How Does an ESPP Work?

Keep in mind that an ESPP is slightly more complicated than purchasing stock through a stock trading app or a website, and there are a few things you have to understand.

First, every stock has an offering period which is the amount of time your employee contributions are deducted from your paycheck via payroll deductions and kept aside by the company to make a purchase.

Purchases are made during a purchase period and on a specific purchase date, which occurs at the end of the offering period. Your purchases will come out of your employee contributions. Your company will keep records and send them to you.

The stocks are purchased at the purchase price, which is the fair market value of the stock on the purchase date, less the discount.

Some ESPPs also have a concept of the lookback period. The benefit of the lookback period is that your discount can often be more significant than 15%.

Assuming the ESPP offers a 15% discount and the lookback period is six months in both scenarios.

Scenario 1

If the company stock is trading at $100 on Jan 1st

and trading at $110 on Jun 30th, you will receive the stock at $85 on Jul 1st.

As a result of the favorable lookback period, your profit is $110-$85 = $25 per stock, which is more than 15%.

Scenario 2

Conversely, if the company stock is trading at $130 on Jan 1st

and trading at $100 on Jun 30th, you will receive the stock at $85 on Jul 1st.

The lookback provision compares the stock’s fair market value at the beginning of the offering period to the stock’s fair market value on your purchase date. Your purchase price is the lower of the two prices.

What Are the Benefits of an Employee Stock Purchasing Plan?

Employee stock purchase plans offer some truly positive benefits that often make them well worth investing in. These include:

Discounted Purchase Price 

There is no question that the most significant benefit of any employee stock purchasing plan is the ability to purchase stock at a discounted price. Getting this stock at the correct offering date will allow you to make a relatively significant profit.

Overcome Investing Hurdle 

ESPPs typically allow you to overcome the hesitancy of investing in stocks. Buying your company’s stock via payroll deductions is an easy step that can make you comfortable investing.

Favorable Tax Treatment

An ESPP comes with favorable tax treatment in qualified plans. Such beneficial taxation occurs because of Section 423 of the Internal Revenue Code.

What Are the Potential Drawbacks of an Employee Stock Purchasing Plan?

While employee stock purchase plans have some outstanding advantages, they are not entirely without disadvantages and potential problems. 

Taxes

While the purchase of shares via an employee stock purchasing plan (ESPP) is not taxed when you make the purchase, they are taxed as ordinary income when you sell the stocks within two years of the offering date. You’ll have to consider any taxes as part of your overall purchase.

Fortunately, if you sell the stocks after this period, they are taxed as long-term capital gains. It can reduce the amount of taxes that you pay on them. Of course, this may also skew your portfolio and force you to take a less-than-favorable position to protect against higher taxes, so this is something that you have to keep in mind when buying or selling stocks via an ESPP.

Regulations

While ESPPs can boost your portfolio, they can also require that you pay attention to some somewhat confusing and obtuse tax laws and regulations. There are paperwork requirements, requirements about how long you can hold the taxes, impacts on your portfolio, and more. As such, you have to pay more attention to regulations with an ESPP than you would with another stock.

Purchase Limits

Before you get ready to take every cent you have and invest it in an ESPP, then sell the money immediately, remember there are limitations on possible purchases of an ESPP. The IRS sets a $25,000 limit on an ESPP each calendar year. It is also very likely that your employer will set a limit. These limitations often hit around 10-20% of the total salary. You’ll have to remember that you can’t spend all your money trying to turn a quick buck on ESPPs.

Opportunity Costs

An ESPP can offer a significant discount and a chance to make a tidy profit. However, there may be opportunity costs.

As great as an ESPP can be, it is always possible that you can make more money by steering your investments to other alternative investments or even real estate investing. If you spend all of your available cash on an ESPP, you ultimately lose the chance to make more or better gains elsewhere.

Comparing stocks vs. real estate gives real estate an unfair advantage on account of leverage. Of course, you need to consider the real estate investment risks.

Also, real estate involves some grunt work. It is not as simple as investing in the S&P 500 unless you consider real estate crowdfunding or note investing.

Why Do Companies Offer ESPPs?

ESPPs have been around for decades. Publicly-traded companies have used them for many reasons, including:

• Retention & Recruitment: In this day and age, it has become increasingly hard to retain and recruit high-quality talent. ESPPs can provide a significant incentive for employees to work for a company. When used correctly, an ESPP can be a substantial bonus to employees as an added compensation benefit. Of course, an ESPP only applies to current employees. Employees must keep working for a company to participate in the ESPP.
• Provide a sense of employee ownership: The intangible impacts of an ESPP can’t be discounted. When working for a company, employees are likely to feel more vital about their place of work if they have a literal sense of ownership. An ESPP allows an individual to own a small piece of their workplace. This enhances their positive feelings towards their place of work. Some studies have found that employees increase their performance when they own a portion of their company.
• Increase capital within a company: By offering an ESPP, a business can increase its cash inflow, using that money to expand operations, make purchases, or fund research. This may be a relatively minor benefit for larger companies, as the amount of money that comes in via an ESPP will likely be a proverbial “drop in the bucket.” For smaller companies, this may be a significant amount.
• Tax deductions: The favorable tax treatment of an ESPP impacts a business in more ways than one, as there are provisions within the corporate tax code that provide incentives and tax breaks for companies that offer an ESPP. As such, it may be worth it for a business to offer this benefit.

What Should I Do if I Am Interested in ESPP?

Remember that you can’t simply call your stock broker and make purchases within an ESPP. You can only make these purchases during an enrollment period through your company. Depending on your company’s ESPP plan, you can usually enroll in an ESPP once or twice a year.

The ESPP plan administrator or HR will send an email to enroll. Once you complete the paperwork, your ESPP purchase will come out of your salary through post-tax deductions.

There are often restrictions on who can own an ESPP. For example, rules often prohibit someone who owns more than 5% of a company from participating in an ESPP and using it to increase their position within a company. This doesn’t stop someone from buying more stock on their own, but it can prevent a founder from taking further advantage of such a program.

There are also often limitations that stop someone from investing in an ESPP if they have not worked for a company long enough. By enacting such a limitation, companies can ensure that a prospective employee doesn’t simply work for a company to take advantage of an ESPP, then leave after a quick sale.

You’ll also need to keep your long-term career plans in mind when making financial decisions, including how to best leverage your human capital. If you plan on leaving your company shortly and pursuing a low-stress retirement job, you should consider not locking in your money during the offering period for the ESPP. 

Keep in mind that any stocks you purchase are yours. You don’t have to return the stocks if you leave a company. But, of course, you will lose access to future purchases.

Finally, make sure to consult with a tax professional about the tax advantages – or disadvantages – of investing in an ESPP. There are unquestionably tax advantages to purchasing stock from an ESPP, but you also want to consider the penalties that may occur when you ultimately sell stock. 

Always subtract potential taxes when calculating your liquid net worth, so it’s essential to keep this in mind before making an ESPP purchase.

Accumulating generational wealth is critical for any individual. An employee stock purchase plan can help individuals that work for public companies to increase their average net worth. With proper planning and research, you can be well-suited to take advantage of employee benefits, including ESPP.

FAQs on Employee Stock Purchase Plan