A Good ESPP Is a No-Brainer

An often overlooked and potentially valuable employee benefit is the Employee Stock Purchase Plan (ESPP). If your employer offers an ESPP we recommend you   1) participate at the level you can comfortably afford  and then  2) sell the shares as soon as you can. This strategy should allow you to lock in a generous return on your contributions while avoiding additional risk on your company stock, which may already represent an outsized percentage of your net worth.

To appreciate why this strategy makes sense let’s cover some basic questions:

  • What is an ESPP?
  • How does an ESPP work?
  • Should you participate?
  • How are ESPP gains taxed?
  • When should you sell the stock you purchase through an ESPP?

What is an ESPP?

An ESPP is a benefit that offers you the opportunity to purchase shares of your employer’s stock at a discount through accumulated payroll deductions.  It is only available for employees of publicly traded companies.  While not all public companies offer ESPPs most of them do.

How does an ESPP work?

ESPPs have an upfront enrollment period where you decide what percentage of your paycheck you would like deducted to buy your company stock at a discount. In most plans you may contribute up to the lower of 15% of your salary (pre tax or after tax depending on the company) or $25,000 each year. Some plans have a minimum contribution on the order of 2% of your salary to participate. Unlike your 401k, your ESPP contributions are withheld from after-tax income (Roth 401(k) plans are an exception).

ESPPs typically have either a 12- or 18-month offering period comprised of two or three six-month purchase periods. Once you enroll, your payroll contributions accrue until your employer uses the accumulated funds to purchase company shares on your behalf on the last day of each purchase period.

The offering period is broken down into six-month purchase periods in order to maximize the value of the benefit. That’s because you are offered the ability to buy your company stock at 85% of its closing price on the lower of the first day of the offering period and the last day of the each purchase period. The 15% discount would be nice on its own, but applying it to the minimum of the two prices makes the ESPP even more compelling.

Allow me to explain with an example. Assume your company has an offering period that lasts one year with two six-month purchase periods that starts on December 15, 2014. Let’s say the closing price of your company’s stock is $100 on December 15, 2014, $90 on June 14, 2015, $95 on December 15, 2015 and $120 on June 14, 2016.

If you earn $120,000 per year and your company allows you to invest up to 15% of your pre-tax income then you can invest up to $18,000 annually or $9,000 in each six-month purchase period. Payroll deductions to purchase stock in the ESPP would begin with your first paycheck after the commencement of the first purchase period on December 15, 2014. On June 14, 2015 (the last day of the first six-month purchase period) you would buy shares of your company stock at $76.50, which is 85% of the lower of the two prices ($90) in the first six-month purchase period. At $76.50, you could buy a maximum of 117.65 shares ($9,000/$76.50).

Here’s where it gets really good.  Most ESPP programs reset the offering period to begin on the last day of the previous purchase period if your stock declined from the first day to the last day. So in this example you would also get to buy your second batch of stock at $76.50 because you could buy at 85% of the lower of $90 (the price at the beginning of the reset new offering period) and $120 (the price at the end of the second purchase period). After  one year you would own 235.3 shares (117.65 + 117.65), which would be worth $28,236 (235.3 x $120). That represents a healthy gain over the $18,000 you paid for the shares.

Should You Participate?

Absolutely! The discount justifies participation unless you cannot afford to live on the smaller paycheck that results from the ESPP payroll contributions.

To understand the range of possible ESPP outcomes, let’s evaluate a variety of scenarios. For this analysis we’ll assume your ESPP starts when your company goes public at $10.00 per share, and, consistent with our previous example, you are allowed to invest a maximum of $9,000 at 85% of the lower of the price at the beginning or the end of each six-month purchase period. The table below assumes five possible outcomes for your company’s stock over the ensuing six months:

  1. Down Big: Your company’s stock trades down to $5.00/share,
  2. Down: Your company’s stock trades down to $7.50/share,
  3. Flat: Your company’s stock stays flat at $10.00/share,
  4. Up: Your company’s stock trades up to $12.50/share, and
  5. Up Big: Your company’s stock trades up big to $15.00/share.

 

 

Down Big

Down

Flat

Up

Up Big

Semi Annual Contribution

$9,000

$9,000

$9,000

$9,000

$9,000

Price on IPO Date

$10.00

$10.00

$10.00

$10.00

$10.00

Price on Purchase Date

$5.00

$7.50

$10.00

$12.50

$15.00

Purchase Price

$4.25

$6.38

$8.50

$8.50

$8.50

Shares Purchased

2,117.6

1,411.8

1,058.8

1,058.8

1,058.8

Sale Price

$5.00

$7.50

$10.00

$12.50

$15.00

Sale Proceeds

$10,588

$10,588

$10,588

$13,200

$15,840

Pre-Tax Gain

$1,588

$1,588

$1,588

$4,200

$6,840

Semi Annual Return

18%

18%

18%

47%

76%

Because the discount is taken from the lower of the price on the IPO date and the purchase date even when the stock is Down Big, Down or Flat, the employee will still have a paper gain of $1,588 on her $9,000 of payroll contributions. That translates to an 18% pre-tax, semiannual investment return and is effectively a floor on the investment return on the purchase date.

If the stock is Up or Up Big then the employee benefits significantly from the upside.  At $12.50/share the employee has a $4,200 gain and at $15.00/share the gain balloons to $6,840. You can see the outcome of the sensitivity analysis in the chart below.

2014-07-24_ESPP

(Price after six months)

Under no scenario do you earn a gain of less than $1,588 in the first purchase period if you sell on the purchase date.

Now let’s analyze the outcome in the second purchase period (the period ending 12 months after the IPO). Suppose the stock ended the first six-month purchase period at $5.00 per share and then the company had a great earnings report and traded back up to the IPO price, $10.00 per share, 12 months after the IPO.

If the employee participates to the $9,000 max in each of the two purchase periods and sells immediately on each purchase date then she will have generated a pre-tax profit of $1,588 in the first purchase period and $12,176 in the second purchase period (($10.00 – $4.25) x  $9,000/$4.25). That’s a $13,764 total gain on $18,000 invested, which represents a 76% annual pre-tax return.

As an alternative scenario suppose the stock closed the 12-month offering period at $9.00 per share (i.e. below the IPO price). Our participant would still have earned a gain of $10,059 in the second purchase period because she was able to buy at 85% of the $5.00 price at the beginning of the second purchase period.

How Are ESPP Gains Taxed?

The tax treatment for ESPPs is unique.  Unlike a 401(k), your contributions to the ESPP are taxed at ordinary income rates. If you hold your shares for more than a year after the purchase date AND more than two years after the beginning of the offering period then any profit above the gain from the discount will be taxed at capital gains tax rates. Remember the holding period for long term capital gains is extended if the offering period resets. If you do not satisfy both requirements then your gain will be taxed at ordinary income tax rates. Gains solely attributable to the discount are always taxed at ordinary income rates (at the time of sale). For example if you purchase shares at a 15% discount to $10.00 per share ($8.50 per share) and you hold the stock for two years from the beginning of the offering period and sell at $12.00 per share then you would recognize ordinary income at the time of sale of $1.50 per share (the discount) and a long term capital gain of $2.00 per share ($12.00 – $10.00).

When Should You Sell the Stock?

The opportunity to benefit from a lower tax rate makes it tempting to hold onto the stock for a year after the purchase.  We encourage you to resist the temptation.  Your stock can always go down and you have now risked even more of your compensation and wealth on the value of your company stock. Instead, use the discount structure to lock in the minimum semiannual return plus any upside from appreciation and sell immediately on the same day you purchase your stock.

You already have a generous return and there’s no reason to take more risk in your company stock by holding it longer than necessary. If you don’t think you will have the discipline to sell your ESPP shares immediately then consider not participating altogether. Don’t get greedy. Paying taxes means you made money.

Bottom Line

An ESPP with an embedded discount is a great employee benefit.  If you can afford it, you should participate up to the full amount and then sell the stock as soon as you can after the purchase date. We would even prioritize participating in your ESPP over your 401(k) plan because it is likely to generate a much higher after-tax return.


Disclosure

Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security.  Financial advisory services are only provided to investors who become Wealthfront clients.  Projected returns are not a guarantee of actual performance.  There is a potential for loss as well as gain that is not reflected in the information presented.  Past performance is no guarantee of future results.

This article is not intended as tax advice, and Wealthfront does not represent in any manner that the outcomes described herein will result in any particular tax consequence. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction.

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