Making the Most of Your Company’s Employee Stock Purchase Plan (ESPP)

When it comes to employee benefits and perks, many of us are familiar with the 401(k) plan and health insurance. And we’ve all heard about those fabulous office cafeterias popular in Silicon Valley and other places. However, there’s another potentially powerful, but often overlooked benefit available at many companies—the employee stock purchase plan (ESPP).  

If your company offers one, an ESPP can provide you the opportunity to purchase shares of your company’s stock, often at a discount to the fair market value. How does it work? You purchase the shares via payroll deductions, which accumulate between an enrollment or offering period and a purchase period.

If you choose to participate, an employee stock purchase plan may provide a valuable opportunity to invest in your company for a discounted price and with favorable tax treatment. It can be an appealing strategy to help grow your wealth and pursue your financial goals. Of course, just because you work at a company does not mean that company’s stock is right for you, you still need to consider your goals and risk tolerance before investing. Let’s look at some of the key aspects of ESPPs you’ll want to consider before signing up.

ESPPs and Taxes

The first factor is taxes. There are two ESPP types that can affect your tax liability:

• Tax-qualified ESPPs meet special requirements under the tax code with a purchase discount of up to 15%. With a tax-qualified ESPP, you pay taxes when you sell the shares—not when you buy them—and no tax is withheld. If you hold the shares for longer than one year from purchase and two years from the offering date, most of your discount will be converted into a long-term capital gain, which is taxed at a lower rate than ordinary income.
• Nonqualified ESPPs don’t meet the special tax code requirements. They work the same way otherwise, but don’t offer favorable tax treatment.

If you’re unsure which type of plan your company offers, ask your company’s stock plan administrator for clarification.

ESPP Lookbacks

Some ESPPs offer a lookback feature that can make them especially valuable. Under a lookback, the discounted price you pay for the shares is based on the stock price at either the start or the end of the offering period—whichever is lower. This provides some protection in case the price of your company’s stock declines in the near term.

ESPPs Can Offer Dollar-Cost Averaging

One appealing aspect of ESPPs is that they involve the regular investment of a consistent amount of money, usually through a payroll deduction. This provides what financial experts call dollar cost averaging, and it’s one way to help manage the risk of market volatility while purchasing stock.

How’s that? When the stock price is lower, you’re able to purchase more shares with the same money. When the stock price is higher, you purchase fewer shares. Because your purchases tend to average out over time, it can make decreases in your company’s stock easier to absorb. That’s because you can buy more shares when things drift south—you’re buying at a relatively lower entry point. (Learn more tips for riding out volatility in your company’s stock price.)

ESPP Holding Periods

With tax-qualified ESPPs, your tax liability is affected by how long you hold the shares. If you sell your ESPP shares more than two years after the start of the offering and one year after your purchase date, most of your purchase discount will be converted to long-term capital gains and taxed at a lower rate than ordinary income. So making the most of a tax-qualified ESPP often involves holding the shares long enough to receive that favorable tax treatment.

Some companies impose their own holding periods for ESPP shares because they don’t want employees to purchase discounted stock and then sell it immediately. Again, ask your ESPP administrator if you’re uncertain whether your company requires you to hold shares for a minimum length of time.

Employee Stock and Portfolio Diversification

If you're considering participation in an ESPP, it's important to analyze the impact on your overall investment portfolio. Consider treating your company’s stock as you would other securities in your portfolio. Are your assets balanced to reflect your unique goals and risk tolerance? (Here’s a more in-depth look at equity compensation and diversification.)

Seek Advice from Qualified Experts

Talk to your TD Ameritrade Financial Consultant about how ESPP participation can help you pursue your financial goals. If you have any questions about how your ESPP participation could affect your tax liability, consult your tax advisor.

This article was developed with input from myStockOptions.com.