Employee Stock Purchase Plans, or ESPP’s, are one of my favorite under-cover savings mechanisms. They present a great opportunity to squirrel away some money without thinking about it too much. In fact, my Employee Stock Purchase Plan at a previous company was precisely the way we were able to afford to pay our wedding in cash and save up for a down payment.
If you’ve got the option to participate in one at work, they can be great. But there are some things to look out for that could catch you off guard.
Basic of ESPP’s
I’ve outlined the basics of Employee Stock Purchase Plans before, but the concept is simple. Let’s talk about Kristin’s plan – a 423(b) Employee Stock Purchase Plan. She’s able to put away up to 10% of her gross paycheck toward the purchase of company stock, up to a maximum amount each year.
For what it’s worth, we’re nowhere near that maximum ($25k, and you’re ineligible if you own more than 5% of the company).
Shares are purchased once a quarter, based on the lower of the start of quarter trade price and end of quarter trade price. Say for example the stock trades at $65 at the start of the quarter – January 1st – and then later at the end of the quarter, the price rises to $70. When the shares are purchased for you, since they’re done at the lower of the two, you purchase them for $65. And you get a discount (in our case, 15%) on top of that.
This means that we effectively could purchase stock, currently trading at $70, for just $55.25.
There are other ways that ESPP’s can be structured; for example by employer contribution matching, varying discount percentages, etc. If you have an ESPP available to you, check with your HR/Compensation teams for specifics.
You can already see the beauty of an ESPP. Since you’re getting shares at an immediate discount, you can sell them. Doing so locks in a 15% immediate return – but you’ll be taxed on that money as regular income, so the returns are realistically a bit less.
Still, even if the gains are taxed, it’s hard to pass up a nearly-guaranteed return of that magnitude.
When we sell shares they go directly into savings. That reminds me, I need to update our Money Map to account for this.
Our savings rate effectively gets increased for “free”
Since shares are purchased once a quarter, but the money taken out each paycheck, it takes a while to see your money on this. It’s not the end of the world, but it can catch you off guard.
Why Not Hold?
The decision of whether to sell or hold your shares comes down to personal preference, but we sell. And the reason for that is simple: risk aversion.
Paying income tax on the gains is not ideal; it’d be much better to just pay long-term capital gains tax, of course. But doing so exposes you to unnecessary risk. For starters, you’re eliminating that guaranteed return for the hope of a better long-term result. Market volatility – especially on a single stock – is real and can ruin your “plans” to hold until you can sell for long-term capital gains.
But here’s the biggest kicker: you don’t want all your eggs in one basket. Suppose your company goes bankrupt suddenly. Think it won’t happen? I bet the folks at Enron or Bear-Stearns or Lehman Brothers didn’t think so either. And yet, many lost their jobs and if they were heavily invested in company stock, also their life-savings, basically in the blink of an eye.
If I can get a guaranteed 15% return less taxes once a quarter, you bet I’m doing it. Passing this up doesn’t really make sense.
Do you have an Employee Stock Purchase Plan at work?