Become a better investor
Lesson in Course: Finance at work (advanced, 10min )
My company allows me to purchase stock at a discount. Is this too good to be true, and what do I need to know?
As an employee at a public company, what is keeping me from joining the next UBER in hopes of striking it big? Retaining talent and hiring is a challenge every company faces, and for public companies, the executives understand the need to compensate employees with equity, ownership in the company. Read more about why equity matters.
Equity ownership for public companies often comes in the form of RSUs and ESPPs. An Employee Stock Purchase Plan (ESPP) allows us to buy shares in the company we work for directly through our paychecks with after-tax dollars.
Most ESPP plans allow employees to participate unless they already own more than 5% of the company’s stock. This exception prevents most founders and c-suite executives from participating. Some ESPP plans may also have eligibility requirements that require us to work at the company for a minimum of a year before we can participate.
When we choose to participate in our company’s ESPP, we need to select how much we want deducted from our paychecks. This deduction can be either a specific dollar amount or a % of our take-home pay. The maximum amount we can deduct is $25,000 dedicated to ESPP per year.
Nothing happens until the offering date (the start date). After the start date commences, the company automatically deducts our ESPP election from our paycheck after taxes. The cumulative money is set aside in an account over the offering period. And at the end of the offering period or on the purchase date, the accumulated cash is used to purchase shares at a 15% discount. Depending on each company’s plan details, the purchase date could happen over multiple intervals throughout a year, e.g., once a quarter or once every two quarters. The company opens a brokerage account on our behalf where we can choose to sell our shares.
The most significant advantage of an ESPP plan is that as an employee we can purchase stock in the company with up to a 15% discount to the current market price! That’s practically 15% free money going into our pockets since we can immediately sell our shares and lock in the profit.
Certain ESPPs have a special provision called a “Lookback,” which allows us to purchase shares at the better price of the stock at the purchase date or the offering date.
Since we are getting shares at a discount, the immediate gain is taxed as ordinary income. However, as long as the company’s plan follows guidelines, the plan can be categorized as a qualified ESPP. We can defer the income tax owed on all qualified ESPP until we sell our shares.
Guideline requirements for tax benefits:
The shares we purchase through an ESPP are our shares, and we can sell them at any time at our discretion unless our company has imposed blackout periods to protect against insider trading.
Taxes owed while selling:
For extra insight, check out the video by expert Mike Zung, CFP® over on the Watch tab!
If we are offered an ESPP, it’s almost always a good idea to participate. We should first confirm with the company that the current plan falls under a “qualified ESPP” so that we aren’t surprised by a big tax bill. Secondly, we should ask if there is a lookback provision covered by the plan.
Lastly, we should always prioritize our 401(k) before an ESPP, even with the 15% discount. With an ESPP, our risk is concentrated in the stock of the company, while our 401(k) offers diversification.
An equity incentive plan that allows us to buy shares of the company we work for directly through our paychecks with after-tax dollars. Often these shares can be purchased at a discount of up to 15%.
A provision included in some ESPP plans allowing us to purchase shares at the better price of the stock at the purchase date or the offering date.
Contributed to ESPP: $12,500
Offer date price: $100 per share or $85 per share after 15% discount
Purchase date price: $150 per share or $127.50 per share after 15% discount
$12,500 / $85 = 147 Shares purchased compared to $12,500 / $127.5 = 98 shares purchased.