Tax-Smart Investing: Strategies for Optimizing Employee Stock Purchase Plans

Learn what an employee stock purchase plan (ESPP) is and how to take advantage of it if your Company offers this plan. ESPPs are an underutilized wealth building tool (only ~37% of eligible employees participate in an ESPP, according to Deloitte) that effectively provides ‘free’ money to eligible participants if utilized properly.

Understanding ESPPs

ESPPs are a benefit offered by companies that allow their employees to buy up to $25,000 per year of company stock at a discount (typically 15%). The neat part about these plans is that most ESPPs have a 'lookback provision', allowing you to buy shares at an even lower price making it a powerful wealth-building tool. Once you enroll in an ESPP, you choose a percentage of your salary to go towards it. Your company then starts taking contributions from every paycheck until the end of the current purchase period (typically 6-month window), at which point they buy discounted stock for you. It's a simple and effective way to boost your income.

Techniques for Maximizing Your ESPP

1. Choose to participate in your ESPP during the enrollment period

2. Decide what percentage of your income you want to invest

3. Understand the details of your ESPP, including any discounts or lookback provisions

Example of an ESPP in Action

Bob makes $90,000 per year and decides to contribute 10% of his salary to the ESPP. This ESPP has a 6-month purchase period with a 15% discount. A 10% contribution would mean $750 per month goes towards this plan for a total of $4,500 in 6 months. If the share price is $100, Bob is able to buy at $85 and lock-in a 17.6% return if he sells immediately. An additional kicker is the lookback provision which many plans offer. With a lookback provision, Bob will receive the lower price set at the beginning of the offering period or at the purchase date (six months later). Let’s say the price of the stock was $90 at the beginning of the period. With the lookback provision, Bob is able to buy the shares at a 15% discount from $90 or at $76.5 per share, locking in a ~31% risk-free return if he sells the shares immediately. By selling shares immediately, this is a disqualified disposition which is subject to short-term capital gains tax (same rate as ordinary income taxes).

Why Paying a Higher Tax Rate is Worth it for ESPPs

In most instances, selling the discounted stock immediately is the better option to lock in your gains and diversify your wealth. Don’t lose site of the forest for the trees or let the tail wag the dog and focus all of your decisions on trying to save a bit on taxes. In many instances, you will come out ahead by waiting but the risk may not be worth it and your ‘risk-free’ investment becomes quite risky in a concentrated position at the company where you work. This is a great example of not putting all your eggs in one basket. Be grateful for your risk-free 17.6% return (which is higher in most cases) as many people do not have this option through their employer.

ESPPs are one of the best employee perks available at some public companies but are grossly underutilized by employees…make sure that you take advantage of this ‘free’ money.