Employee Stock Purchase Plans (ESPPs) are a benefit companies offer their employees. ESPPs present a unique opportunity to buy company stock at a discounted rate, with the possibility of tax advantages. By participating in these plans, employees become investors in their employer’s success, making ESPPs a valuable inclusion in compensation packages.
This article will break down how an ESPP works, the key differences between qualified and non-qualified ESPPs, and how to invest company stock in your plan.
What Is an ESPP and How Does It Work?
ESPPs let employees purchase company stock at a discounted rate using their paychecks. This is done through a predetermined number of payroll deductions — typically 6 to 12 months — over a specified time. At the end of the period, the employee’s accumulated contributions are used to buy company stock at a discounted price. Employees can then choose to keep or sell their shares once they have reached the vesting period, which is usually 18 months after joining the plan.
ESPPs also provide potential tax savings depending on whether it is qualified or non-qualified. Qualified plans are subject to certain restrictions and limitations set out by the Internal Revenue Service (IRS). In contrast, non-qualified plans do not have any limits. However, they may be subject to taxes depending on when shares are sold and how long they were held.
The Risks and Rewards of Investing in ESPPs
When investing in a company’s stock through an ESPP, investors must understand the risks and rewards associated with participating in such plans. While there is potential for savings due to the discounted price of shares purchased through an ESPP, there is also risk involved. There’s no concrete guarantee that these shares will increase in value — the value could decrease if market conditions change. Therefore, investors generally consider other factors when considering participation in an ESPP, such as company performance.
Ultimately, only individuals confident that their employer will perform well should consider investing in its stock through an ESPP. With this knowledge, employees can make informed decisions about investing in their company’s stock and taking advantage of potential savings through ESPPs.
Top 5 Benefits of Participating in an ESPP
- Stock purchase at a favorable rate: ESPPs allow employees to buy company stock at a discounted price, often below the market value.
- Long-term financial growth: Employees become shareholders and have the potential to benefit from the company’s long-term growth and success. As the company’s value increases, their stock holdings can also appreciate, leading to potential financial gains.
- Tax advantages: Qualified ESPPs often come with specific tax benefits, such as preferential tax treatment on the gains realized from selling the stock. Employees may sometimes qualify for favorable capital gains tax rates if they hold the shares for a certain period.
- Convenient payroll deductions: ESPP contributions are typically made through automatic payroll deductions, making it easy and hassle-free for employees to participate. These regular deductions help employees build their stock portfolio over time.
- Improved employee engagement: ESPPs can act as a powerful employee incentive, motivating and engaging the workforce to contribute to the company’s success. By aligning employees’ interests with the company’s performance, ESPPs can foster a sense of ownership and commitment among employees.
When Can an Employee Sell ESPP Stock?
Employees can sell their ESPP stock if certain conditions are met. The company must have been publicly traded for at least two years, and the employee must also hold the stock for at least two years from the grant date and one year from the purchase date. It’s important to note that these periods do not overlap — they must be consecutive. For example, if an employee were granted a purchase right in April 2019, they would need to wait until April 2021 before being eligible to sell their stock.
To sell ESPP shares, employees need to use a broker or other financial institution. Investors must understand when to sell their ESPP stocks to maximize available investment opportunities and minimize their tax liabilities. By understanding these criteria, investors can decide how long to hold onto their stock before selling it off to maximize profits and limit losses.
Qualified and Non-Qualified ESPPs
There are two kinds of ESPPs: qualified and non-qualified. Qualified ESPPs are eligible for preferential tax treatment. However, they must meet specific requirements, such as a minimum offering period, limits on the number of shares that can be purchased, and limits on the stock price.
Qualified ESPPs typically have an offering period of at least six months. They also usually require that employees purchase a minimum number of shares during the offering period. The maximum number of
shares that can be purchased is generally limited to 15 percent or $25,000 per year (whichever is lower). The stock cannot be bought at more than 85 percent of its fair market value.
On the other hand, non-qualified ESPPs don’t qualify for preferential tax treatment. However, they offer more flexibility since they don’t have to meet specific requirements. The most significant difference between qualified and non-qualified plans is how taxes are calculated when selling the stock acquired through an ESPP. With a qualified plan, taxes are calculated using the discounted purchase price, whereas with a non-qualified plan, taxes are based on the market value at the time of sale.
Before participating in an ESPP, it’s important to analyze your financial goals and determine which type best suits your individual needs. You should also consult with a financial advisor or tax professional. Their expertise can help you make informed decisions, optimize financial benefits, and align ESPP investments with your broader financial goals, reducing potential risks and ensuring tax efficiency.
Understanding the Qualifying Disposition
To qualify for this treatment, the employee must hold the purchased shares for at least one year from the date of purchase and two years from the start of the offering period. By meeting these holding period requirements, the employee becomes eligible for preferential tax treatment, typically subjecting the gain on the sale to long-term capital gains tax rates rather than ordinary income tax rates, potentially resulting in lower tax liabilities.
On the other hand, if an employee sells the ESPP shares before meeting the qualifying disposition requirements, the gain on the sale may be treated as ordinary income and subject to higher tax rates. Failing to meet the holding period requirements could lead to less tax-efficient outcomes and potentially higher tax obligations for the employee.
It’s crucial for employees to understand the qualifying disposition rules of their ESPP to make informed decisions regarding the timing of their stock sales. By adhering to the qualifying holding period, employees can take advantage of preferential tax treatment, potentially increasing their after-tax returns and optimizing the benefits of participating in an ESPP.
Find out how Astrella can give employees a clearer view of their company’s financial structure.
How To Invest in Your Company’s Stock Through an ESPP
Investing in your company through an ESPP is a great way to build a nest egg for your financial goal, whether it’s retirement, traveling, or passion projects. First, however, it’s important to understand the regulations and rules associated with ESPPs and eligibility requirements.
To begin, be sure to check if you are eligible for your company’s plan. Factors like employment length, salary level, or other criteria set by the employer typically come into play. In addition, find out how long the offering period lasts. Usually, ESPPs allow employees up to 12 months after the offering date to
purchase shares. You should also find out what type of stock can be purchased – generally, only common stock is offered through an ESPP.
You should also take a deep look at your finances and estimate how much money you can afford to invest in an ESPP. Research your company’s stock performance and potential prospects before investing funds. To ensure that all tax implications are accounted for, talk with a financial advisor or tax preparer before enrolling in an ESPP program. Lastly, when deciding on how much of your salary should go towards investing each pay period (15% is the norm, but by no means a blanket recommendation) consider any other retirement accounts or investments you regularly contribute towards and think about what it is you want out of this investment opportunity in terms of returns. With this information, you’ll be better positioned to make informed decisions about investing in your company’s stock via an ESPP.
Getting Started With ESPPs
When it comes to planning your financial future — and including the company you work for in those plans — it’s critical to have an accurate view of that company’s financial structure. Find out your company’s offerings and seek help from experts who understand the potential risks and benefits of purchasing company stock.
Find out how Astrella’s intuitive software can help employees keep track of their company stock options and have a clearer view of their financial future.