Employee Stock Purchase Plans (ESPPs)
One benefit often available to employees of publicly-traded companies that is frequently overlooked or under utilized, is to have access to what are called “Employee Stock Purchase Plans (ESPPs)”. When used correctly, these plans can provide a wonderful investment opportunity and long-term financial benefit to the employee. However, I often see people fail to take full advantage of these plans when offered, and for many who do partake, I see them make the same mistakes over and over again in the management of these plans. Here, I will discuss both the positive potential aspects of a well-implemented ESPP, as well as the most common mistakes and pitfalls to avoid.
An Employee Stock Purchase Plan, or ESPP, is a plan provided by an employer of a company that is publicly traded, which allows employees to purchase company stock directly from the company, usually at a discounted price. For example, if you work for IBM, the ESPP is a plan that allows you to buy IBM stock directly from IBM at a discount from the current market price of the stock. It is important to note that there are actually two types of ESPPs — qualified and non-qualified. Only qualified plans, by far the most common type of plans in the marketplace, are recognized and regulated by the IRS, and these are the type of plans we will be focusing on here.
The first benefit to investors using an ESPP comes from its simplicity and ease of use. The stock purchased in an ESPP is bought directly through payroll deductions. Just as in contributions to a 401(k), or payments for your company-provided health insurance, money is taken directly from your paycheck each pay period, so you can set up the plan and basically be on autopilot going forward. The relative ease of setting up and making contributions to these types of employer-provided plans make them a great way to get invested, and continue to invest on an ongoing basis, without a whole lot of upfront or continuing work.
ESPPs are also great because they usually allow the investor to avoid paying commissions on the purchase of the stock. One of the biggest issues with being a smaller investor trying to buy small amounts of stock over time, is that commissions and fees can quickly eat away at any potential profit. However, this is not the case with most ESPPs, as, generally speaking, there are no fees or commissions for buying stock through the company-provided ESPP.
The greatest benefit of an ESPP is that, in most circumstances, you receive a significant discount on the stock price when purchasing stock through the plan. This discount can be as much as 15%. In other words, if the stock is currently trading at $100 per share on the open market, an employee covered by an ESPP through work can purchase the same stock for the discounted price of $85 and have an instantaneous, unrealized gain of 15%. This is truly a remarkable deal and something not to be missed, if at all possible.
Because of the benefits described above, I almost always recommend that my clients take full advantage of ESPPs when offered. But, of course, there are some potential drawbacks and pitfalls when using these plans that participants should be aware of before diving in.
The first possible issue that arises in connection with buying company stock through an ESPP is that you have to have discretionary income each paycheck. In order to buy stock, you have to have the money to do so, and it has to be available to be deducted directly from your paycheck. If you are living paycheck to paycheck, and contributing to an ESPP would force you to build up credit-card debt to pay your bills and fund your lifestyle, then using an ESPP may not make sense. Assuming this is not the case, and you have at least some discretionary income each month, using an ESPP is almost always a good idea, as long as you pay attention to the following guidelines.
As anyone who has ever talked to me about investing knows, I never recommend holding an undiversified portfolio. In general, I recommend that individuals never have more than 5% of their portfolio invested in any one stock, and really, 2% or less is ideal to my mind. As such, if you are purchasing stock through an ESPP, and letting this stock accumulate over time, you can quickly find yourself in a situation where you are holding an undiversified portfolio. Now, I don’t like holding undiversified portfolios in any situation, but it is especially dangerous when the undiversified stock position consists of the stock of the company you work for. You already have your paycheck tied to this company. You likely already have your health benefits tied to this company. You very well may already have your life insurance tied to this company and on and on. Basically, that is, you already have a whole lot of eggs in this one company’s basket. Do you really want to add another egg to the same basket? And, while it is very hard to change the fact that you have your income and health care and all those other things tied to that one company, it is easy to remove the investment egg from the equation, and that is exactly what I recommend that you do.
As I have mentioned already, I very much like ESPPs and almost always recommend that my clients take advantage of them. However, I also generally recommend that they sell the stock and diversify as quickly as possible. In other words, buy the stock, get the discount, and then immediately (or at least as soon as possible) sell the stock and diversify the proceeds. Now, this goes against the grain of how most people advise employees to use these types of plans. The general rule is for investors to hold the stock purchased in an ESPP for at least two years from the offering period and at least one year from the purchase of the stock. That’s because, if you do wait, then when you sell your shares, it is considered a “qualifying disposition,” and the gain (beyond the discount, which is always taxed as ordinary income) is taxed at “capital gains” rates. If, on the other hand, you take my advice and sell the stock as soon as possible, and then use the proceeds to invest in a diversified portfolio, it is considered a “disqualifying disposition” and you pay ordinary income tax rates on your gains (not capital gains).
All other things being equal, based on the current tax structure in America, capital-gains rates are better (i.e. lower) than ordinary income-tax rates. However, in my opinion, they are not so much better that the tax tail should wag the investment dog completely. Sure, in a perfect world we would all like to pay lower taxes. But, I believe that the protection you receive from diversifying your portfolio, and taking some of the eggs out of your employer’s basket, far outweigh the downside of potentially paying a slightly higher tax bill when you sell the stock. How quickly could a drop in the stock’s share price, while holding the stock for one or two years, wipe out the potential tax savings? It could potentially happen in a day, and it could very well happen in the one-to-two year holding period required to be considered a qualifying disposition that allows you to receive preferential tax treatment.
I can’t stress this lesson enough, and not just with regard to ESPPs: DO NOT let the relatively small tax tail wag the much larger investment-decision dog. Of course, everyone’s tax situation is different, and all tax matters should be discussed with your CPA, but in almost every situation I have come across, the benefits of diversification and prudent investing have outweighed the possible tax savings of holding an undiversified position of employer stock.
ESPPs are great and should almost always be taken advantage of to the fullest extent possible. Just make sure you have the income needed to purchase the shares without going into debt, and then make sure to use these plans correctly. And, most importantly, don’t let the that nasty five-letter word “taxes” ruin a good investment decision to be a prudent and diversified investor at all times.
Disclosures
We are not tax-experts and are not offering tax-advice here. Please discuss all tax matters with your tax-consultant and/or attorney before making any decisions.The commentary on this website reflects the personal opinions, viewpoints and analyses of the Topel & DiStasi Wealth Management, LLC employees providing such comments, and should not be regarded as a description of advisory services provided by Topel & DiStasi Wealth Management, LLC or performance returns of any Topel & DiStasi Wealth Management, LLC Investments client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment