An employee stock purchase plan offers you the opportunity to purchase shares of ownership in the company you work for.
Often at a discounted rate too! After working with hundreds of clients with all different types of ESPPs, these are the 3 strategies I have found to be most effective.
1. Selling All Shares Immediately After Purchase
> With this approach you sell all of your shares immediately after you purchase them to lock in your gain earned via the discount.
Ex: If your plan offers a 15% discount and the shares are valued at $100/share on the purchase date, you’ll purchase the shares for $85/share and then be able to turn around and sell those shares for $100 each. In this scenario, the return on your investment would be $15/$85 = $17.65%.
Advantages:
- You maintain the least amount of market risk possible while still participating in the plan.
- By selling the shares immediately after purchase, you’re unlikely to see a significant taxable gain on the position vs. its purchase price.
Disadvantages:
- Once shares are purchased, they often take up to a few business days be available for sale.
Appropriate for:
- Those who are not interested in owning their company’s stock but want to earn a competitive short-term return on their money, with relatively little risk.
- Those in lower income brackets where the difference between the capital gains rate and their income tax rate is not as significant.
2. Selling Once You Qualify for Favorable Tax-Treatment
> With this approach, you’re participating in the plan and purchasing shares, but only holding them as long as you need to for the tax benefits.
For qualified ESPPs, if you hold your shares for
at least 2 years from the offering date AND at least 1 year from the purchase date
then, any appreciation since you’ve purchased the shares will be taxed as capital gains instead of as income.
Advantages:
- You will only maintain the risk associated withholding the shares for a limited amount of time.
- If the shares have appreciated since their purchase date, then your tax savings can be significant.
Ex: Let’s say you purchase $10,000 worth of shares whose value has increased to $15,000 by the time you’ve met the holding period requirements and have decided to sell. The $5,000 in appreciation will be taxed as capital gains instead of being taxed as income. If your effective income tax rate is 35% and your capital gains tax rate is 15%, then you’ll save 20% or $1,000 ($5,000 x 20%).
*This illustration is hypothetical and is not meant to represent any specific investment or imply any guaranteed rate of return.
Disadvantages:
- By holding the stock for the required holding periods, you run the risk that the position could decrease in value, potentially wiping out your gains and negating any potential benefits you would get from satisfying the holding periods.
Appropriate for:
- Those in higher federal income tax brackets where the difference between their capital gains rate and the income tax rate is significant.
- Those who live in states with higher income taxes (for the same reasons as above).
3. Buy and Hold
> With this approach, you participate in the plan, purchasing shares and holding them as a long-term investment.
Advantages:
- By holding the stock, you stand to benefit not only from the potential appreciation in your company’s stock, but also from any potential dividend payments made to the shareholders.
- If you never sell the shares, then they could pass to your heirs at a stepped-up cost basis – meaning the any appreciation in the shares during your lifetime, won’t be subject to taxation.
Disadvantages:
- If your company’s stock doesn’t perform as well as other investment options, you may have been better off not maximizing your investment into the plan.
- In the worst-case scenario, if your employer’s business starts to fail, not only may the stock decrease in value, but you may lose your income as well, should you face a layoff.
Appropriate for:
- Investors with large external portfolios: If maximizing purchases through the plan results in a company stock position that is less than 5% of your overall investment portfolio, then concentration risk will be less of a concern.
Final Remarks
An ESPP is an employee benefit! You should be glad that your company offers one if they do. It’s a common benefit to working at a company that is publicly traded, and one that you often won’t have if you’re self-employed or working for a private company.
Evaluate your plan closely. ESPPs can be complex plans with company-specific details and features (e.g., lookbacks, blackout dates, contribution limits, etc.) all of which affect the strategy that will be appropriate for you. Together, we can work to keep you on-track towards your financial goals.
Request a consultation with me to learn more.
Read more articles by Roman Moriarty