When you begin to work at a larger company, you may be presented with the option to purchase stock at a rate lower than market share value. While plans differ, participating in one of these Employee Stock Purchase Plans could benefit your finances a great deal.
Often, people are interested in investing but have little capital to put towards their desires. If this sounds familiar to you, you might be able to use the stock purchase plan to create flexibility in your budget that will allow a bigger investment than you could previously afford.
You can use the gains to pay off debt, travel, or save for the purchase of a home. Before you begin participating in the program, it’s important that you understand exactly what they entail and how you can use them to your benefit. We’ll go over a few key points to help you understand what these plans involve, what you need to know, and how they benefit the employee.
Defining the Terms
You need to familiarize yourself with the terms you will hear and what they mean to your plan.
Option-Your option to purchase stock.
Offering period-The set time frame in which you can buy stock.
Offering date- The offering period start date.
Purchase/exercise period- Time frame in which purchase price is determined that is followed by a purchase date.
Purchase/exercise date- The date your stock is purchased.
Purchase/exercise price-The price of your stock purchase.
Automatic low offering period-Automatically terminates on the purchase date if the price of a share is lower than what the price was on the offering date.
Different Types of Employee Stock Purchase Plans (ESPP)
ESPPs typically come in a few different models:
Qualified-qualified plans require shareholder approval before they are organized and every participant has equal rights. There is a maximum time limit of 3 years on all offerings and restrictions on any discount offered through the plan. More can be found by researching Section 423 of the Internal Revenue Code.
Unqualified– There are less restrictions but these plans do not convey the tax advantage of after-tax deduction that a qualified plan does.
You can only purchase into a ESPP after the commencement of the offer date, and depending on your company, there may be several offering dates in the fiscal year. Your company plan may have a built in opt-out for employees who own more than a certain percentage of stock, making your investment capabilities limited. The IRS also restricts employee contributions to a rate of $25,000 annual contribution.
Tax rules on ESPP are often confusing, so we’ll list them according to the plan your company offers.
Qualified– taxed during sale time period. The discount offered is taxed as income, the gain is taxed at a separate long-term gain rate.
Unqualified– the entire gain may be taxed as income.
What do I mean by “discount” and ‘gain’? Most ESPPs offer stock at a discount rate to employees. Gain refers to the amount of money you’re stock value increases by. If your company offers a ten percent discount on stock that market values at $8 a share, your calculations would look like this:
$8 market value – ten percent = $7.20 cost to you. This automatically places you with an .80 cent lead on market value. That .80c would be taxed at income rate because it’s automatic profit to you.
If during the year stock value increased, the increase represents gain.
What Does This Mean For You?
There’s always a risk when purchasing stock. You are investing your money in the belief that the company will continue to profit and hold value on the business market. By having the ability to purchase stock at a discounted rate, you increase your odds of profiting as you start the process with a lower investment. Someone who purchases the stock at market value will have to see a greater rise in the value before they begin to see a profit on their investment.
You also have the option of allowing the stock to fluctuate lower than someone who purchased at market value, as you carry a lower loss point than others. This may help you ride out the stock market fluctuations that occur.
Be sure to read the withdrawal section of any ESPP you are interested in. Companies vary widely in when they allow withdrawal. Some stipulate the employee has until the day prior to the end of the offering period, some set other dates.
Not all ESPPs offer a lookback period, but you may hear the term. A lookback period essentially means that the program allows employees to purchase stock at the lowest price point in the last 3 to 6 months.
ESPPs are considered liquid assets, though the regulations on cashing out differ by plan. Review your plan for rules on cash-out option. Some companies pay a separate check, and some simply include it with your standard payroll.
ESPP Quick Guide
● ESPP purchases are taken after tax calculations.
● ESPP gains are taxed at income rate.
● ESPP gains potentially benefit from tax rates if held for a year following purchase date and a full two years following the start of the offering period.
● ESPP carries some risk as the market fluctuates.
● Given the discount to purchase price, ESPP may be a way to garner short-term immediate gains if your plan allows for immediate sale after the purchase period.
● This immediate gain may produce money for expenses or create capital that can be used to other investments.
● Plans vary for termination clauses. Be sure that you know your options for existing stock if you leave your job. You may have a limited time frame to reclaim your purchases.
If you are seeking to use the gains in an ESPP to fund other investment opportunities, it’s vital to review the sell clauses in your offered program. If you have the option to sell immediately, it’s a no-brainer to participate. Since the purchase price is set not only on the lowest market price but also discounted from that price, the risk of losing your investment is lower.
The discount allows a built-in cushion in which the stock market price would have to fall by a substantial margin before you lost money on the deal. Even if it fell by a smaller percentage, so long as the market share price doesn’t dip below your purchase price, you have made an immediate gain.
This is an attractive feature to ESPPs as it would be difficult to match the return from an interest-bearing account, which often requires minimum balances and penalties for withdrawals. ESPPs allow investment as affordable with only tax owed on gains and do not restrict your access to the funds beyond the time frame illustrated in your plan.
There is a risk of holding on to ESPP to achieve the long-term tax benefits. If, during the two years, the market value price dips by a wide enough margin, you may lose the equivalent of any tax credit you would receive by holding your investment.
In this case, it’s more of an opportunity cost lost, because that money could have been put to use in an investment that would realize actual gains for you had you cashed it out.
In other words, if you have the option to invest and receive the same percentage of return in six months, or in two years, why would you wait for the two years?
Consider the fact that if you have the option to immediately sell, the difference between your purchase price and the market price for your stock could lead to substantial gains. Once you sell and have the additional money, you could invest it in an IRA, 401k, or other market investments. By continuing the cycle over each purchase period, you may be able to generate a sum of money to invest over the year that wouldn’t have been possible before.
If you are considering taking advantage of your ESPP for these purposes, it’s important that you also consult a financial planner. As a fee-based financial planner, I often work with individuals that are interested in finding ways to maximize their investment opportunities while operating from budgets that may not allow immediate large purchases into money markets.
I understand the difficulties in finding ways to plan for your future, pay off student loan debt and manage to save for the purchase of a house while raising a family on a salary. I work with each client to show them how to work with their finances in ways they may not have thought about in order to realize capital gains.
As a fee-only financial planner, my only interest is in helping my clients. I do not receive a commission from any service or plan that I may recommend to my clients.
If you are interested in learning more about ESPPs, investments, and how you can use the money that you already have in your budget in a more productive way, please contact me. I’ve helped many young professionals establish the financial groundwork to begin their journey to achieving their financial goals. I look forward to hearing from you.