What is an employee stock purchase plan? Is it worth your time and money? Well, if you’ve been contemplating enrolling for your company’s ESPP, here is all you need to know.
Getting a reliable source of passive income is the desire of so many people. Everyone wants to have a source of income that doesn’t demand too much effort so that they can concentrate on other things. And investing in good stocks is one way to achieve this.
Many publicly traded companies have found a way to help their employees invest in stocks. Through ESPPs (employee stock purchase plans), individuals can buy stocks at lower prices than those offered in the market. This option is a great way to save money on your taxes and even invest in your future.
However, not all ESPP plans are created equal. Some plans offer better value than others.
That’s why we want to explore ESPPs in detail to help you understand them better. This way, you can easily decide whether investing in an employee stock purchase plan is the best route for you.
So, first things first;
Table of Contents
- What is an Employee Stock Purchase Plan (ESPP)?
- Types of ESPP Stock Plans
- Qualified Plans
- Unqualified Plans
- How Does an Employee Stock Purchase Plan Work?
- Selling ESPP Shares
- Examples of Employee Stock Purchase Plans
- ESPP Alternatives
- 1. Employee Stock Ownership Plan (ESOP)
- ESPP vs 401k
- Pros and Cons of an Employee Stock Purchase Plan
- Is Employee Stock Purchase Plan Worth It?
- Related Resources
What is an Employee Stock Purchase Plan (ESPP)?
An ESPP is a stock investing program offered by employers to their employees. It allows employees to purchase company shares at a significantly lower price than the prevailing market prices.
Usually, the discounted share price can go as low as 15% below the current market price. And they have a vesting period of between 1 and 3 years. However, although rare, some companies might offer discounts larger than 15% and even offer instant vesting.
The employer will usually deduct between 1 and 15% of your salary and use it to buy stocks on your behalf. But, this can only go up to a maximum of $25,000 per year, according to IRS limits. These stocks will be available in your account at the end of the offering period.
In most cases, the employers will purchase shares for the employees twice or thrice a year. It is, therefore, essential that you check with your employer’s HR department to know when the offering period is.
However, not all employers offer ESPPs. So, if you’re looking for a job, it’s something you can use as a bargaining chip during salary negotiations.
Types of ESPP Stock Plans
There are generally two types of ESPP stock plans; qualified and unqualified. Here’s a quick overview of each;
These are the most common type of ESPPs. They come with certain tax benefits that make them more attractive to employees. For instance, with qualified plans, you only pay taxes on the stocks when you sell them.
Also, you get to enjoy a long-term capital gains rate on the sale, which is often lower than the ordinary income tax rate. This makes qualified plans a great way to save on taxes.
Generally, qualified ESPP stock plans need the shareholders’ approval before implementation. And their offering period is set to less than three years.
When it comes to stocks rights, all participants in the plan have equal rights. Also, the stock discounts have some restrictions on the maximum amount a company can offer.
Unlike qualified plans, unqualified ESPPs are not entitled to any special tax treatment. This means that you’ll be taxed on the stocks at your current income tax rate.
The advantage of unqualified plans is that they’re not subject to as many regulations as qualified plans. This way, they are easier and cheaper to set up. Also, there are no restrictions on the offering period or the maximum discount a company can offer.
However, due to the lack of favorable tax treatment, unqualified plans are not as common as qualified plans.
How Does an Employee Stock Purchase Plan Work?
As we have mentioned, an ESPP is an investment plan that publicly traded companies avail to their employees. It allows the employees to invest in the company’s shares at a discounted price.
Usually, the plan requires the employee to agree to a monthly deduction on their salary. This deduction will continue for a period of time (the offering period) until the employer buys the shares for the employees (purchase date).
The offering period can have several purchase dates based on the type and structure of the plan. For instance, there could be a purchase date after every three months or twice a year.
The employees will decide how much they want the employer to deduct from their salaries, up to a max of $25,000 per year. This maximum is set by the IRS and is referred to as the contributing limit.
The employer sets their own terms for the ESPP, including the offering period, discount, contributing limit, and purchase date. However, these terms must comply with certain IRS regulations to qualify for preferential tax treatment.
For example, the offering period can’t be longer than 36 months. Also, employees must wait at least six months (the vesting period) after the purchase date to sell the shares.
Once you have held the shares for the required vesting period, you are free to sell them at any time. If the stock price has gone up since the purchase date, you’ll certainly make a profit.
However, if the stock price has gone down, you will make a loss if you sell at the prevailing price. This is why it’s important to carefully consider the risks involved before investing in an ESPP.
There’s one more thing you should note about the ESPP shares. When buying the shares, you’ll not be liable for any taxes. However, when the selling time comes, things change.
When you’re selling the stock, the government considers the discount you received during the purchase as additional compensation. This way, the government taxes this amount as additional income.
Also, when selling this stock, it will have either gained or lost some value. The price difference is usually reported as a capital loss or gain. And, if it’s a profit, the government requires you to pay capital gains taxes.
It’s crucial to understand and determine whether the profit you make on your investment is seen as capital gain or additional income. This is because one is more profitable than the other.
For instance, normal income tax is higher than capital gain tax. And for this reason, waiting until your investment attracts capital gain tax is recommended. You’ll achieve this by waiting at least 2 years from the stock offering date to sell your stock or one year from the purchase date.
Examples of Employee Stock Purchase Plans
1. Costco Employee Stock Purchase Plan
Costco offers one of the best ESPPs in the market. The plan is available for new and existing employees, who are allowed to buy stocks through payslip deductions.
This ESPP plan includes zero commissions and fees during purchase. It, therefore, means that every coin that’s deducted from your salary goes to the purchasing of the stocks.
The best thing about Costco’s ESPP is that it offers more than just tax benefits. The employees receive a 15% discount on the purchase price. It is a great deal considering that most companies offer between 0-15% discounts.
2. Apple Employee Stock Purchase Plan
This is another generous employee stock purchase program. Just like Costco, new and active Apple employees are eligible for the program.
Here, the stocks are sold at a discount, and the employees are at liberty to hold or sell the stocks when they want. Generally, Apple divides its plan into two sections; a one-month enrollment period and 6 months offering period.
The enrollment period includes two dates; the 1st of January and the 1st of August. The Offering period also has two entry points; the 1st of February and the 1st of August. Typically, the offering period is when the salary deductions are made, which happens twice a month for Apple.
After the offering period is over, the company decides the stock purchase price and buys the share on their employees’ behalf. Usually, the price is calculated as 15% of the lowest price between the price at the start of the offering and that at the end of the offering. For instance, if the stock price at the start of the offering is $150 but rises to $185 by the end of the period, the discount is calculated as 15% of $150.
3. Adobe ESPP
Adobe’s ESPP is undoubtedly one of the best ESPPs around. This means that if you are an employee here or a prospective one, you certainly should consider enrolling in the plan.
Like several other big tech companies, Adobe’s ESPP discount reaches a high of 15%. However, unlike some ESPPs that offer a 6-month offering period, Adobe offers a 24-month long offering period. This translates to four, 6-months purchase periods.
The plan also has a lookback feature. Here, the share price is determined by applying the discount to the price at the beginning of an offering period or the end of a purchase period.
If you are an employee at Adobe, your contribution limit is set at 25% of your salary. However, no matter how much you contribute, you can only buy stocks worth $25,000. Therefore, if the price per share is $100 you get to buy 250 shares.
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4. Microsoft ESPP
Microsoft ESPP is not any different from other employee stock purchase programs. It is designed to allow employees to get a slice of the company’s ownership and make money through salary deductions.
The program acts more like the 401(k) plan in terms of deductions. However, the ESPP deductions are made after-tax, while in 401(k), they come before tax.
As for the discounts, Microsoft offers a price up to 10% below the fair market value. And, you can contribute up to 15% of your monthly salary towards this plan. The company purchase shares for the employees every quarter.
Once you have your shares, you are free to sell or hold them and sell them later. But, you should note that the selling prices will be affected by the stock’s price fluctuations. Therefore, you should be able to determine when you’ll make good profits and sell your shares then.
1. Employee Stock Ownership Plan (ESOP)
This is among the most common stock benefit plans designed to enable employees own company stock. The plan helps to reward and motivate employees, as well as give them a chance to borrow money to buy new assets. ESOPs are quite common in private companies, unlike ESPPs, which are common in publicly traded companies.
Generally, ESOPS are long-term plans in which owners can only cash in when they leave the company or retire. Unlike ESPPs, ESOP plans don’t require the employee’s contribution. Instead, they are like rewards or compensation in the form of stock stored in an employee’s account in the company.
Once the employee wants to leave the company or is retiring, they sell back the shares to the company and receive cash.
Generally, there is no vesting for these tax-deductible stocks. However, to qualify for ESOPs, you must have worked for the company for three years. Also, you can only receive benefits on this stock while working if you own 5% of company shares and are over 70.5 years old. Otherwise, your wait until retirement or leave the company.
2. Restricted Stock Units (RSUs)
Both public and private companies offer RSUs to their employees as a form of compensation. RSUs are given to an employee with conditions that prevent the employee from selling or transferring the units until they satisfy the vesting period.
According to a 2019 report by Deloitte, this is the most common type of employee equity compensation. And is granted to any employee regardless of their level or industry.
Usually, companies will award RSUs to their employees, but with certain conditions. For instance, you don’t get your stock shares on the allotment date. Instead, you must first satisfy the vesting requirements.
The good thing about this type of company stock ownership is that you don’t contribute any cash. They are a form of reward.
3. Employee Stock Options (ESOs)
ESOs are given to an employee as an incentive to achieve certain goals or objectives. For example, a company might give its sales team ESOs, with a target of increasing sales by a certain percentage over the next financial year.
These options give employees the right to buy shares at a set price within a certain period. However, the employee is not actually buying these shares. But, if they exercise their right to buy, they can earn a profit if the stock price rises.
ESPP vs 401k
Both the ESPP and the 401(k) are great employee benefit plans. But, they have some significant differences. For starters, the ESPP gives you the chance to contribute part of your salary towards acquiring the company’s stock.
This is an excellent chance to make passive income, especially since you get those stocks at a discounted price. Also, you won’t feel the pain of buying these shares since the money is deducted directly from your salary and in small bits (as you decide).
On the other hand, a 401(k) plan is a retirement savings plan. It allows you to contribute a certain percentage of your salary towards the plan. This money is then invested in stocks, bonds, mutual funds, and other assets.
The main difference between these two options is that with an ESPP, you’re buying company stock with the hope of making profits when selling them later. On the other hand, a 401(k) plan is designed to help you save for retirement by investing your contributions.
Also, the deductions in an ESPP plan are deducted after-tax, while those of 401(k) are pre-tax. This means that with 401(k), you get the chance to lower your taxable income.
Pros and Cons of an Employee Stock Purchase Plan
ESPPs are a great way to acquire company stocks from your employer. But, when deciding whether an ESPP is right for you, it’s important that you weigh its pros and cons.
- You get to buy company stock at a discounted price
- The plan is flexible, and you can choose how much you want to contribute
- It’s a great way to save for retirement
- You can sell your shares anytime after the vesting period
- They are easy to join
- The plan gives you a sense of the company’s pride
- The stock might not be worth anything when you sell it due to price fluctuations
- You might not be able to sell the stocks immediately due to vesting requirements
- It might not offer desired results, especially if the stock prices don’t raise
Is Employee Stock Purchase Plan Worth It?
The answer to this question is not straightforward. It depends on your goals and objectives. If you’re looking for a long-term investment, then an ESPP might be a great option for you.
However, if you’re looking for something that can give you quick profits, then an ESPP might not be the best option. All in all, an ESPP offers more benefits than drawbacks. For starters, you get stocks of the company you work for at a lower price and can sell them any time after the vesting period.
This means that ESPPs are an excellent way to improve your financial status, especially if there is a steep increase in the stock value.
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Kyle Kroeger, esteemed Purdue University alum and accomplished finance professional, brings a decade of invaluable experience from diverse finance roles in both small and large firms. An astute investor himself, Kyle adeptly navigates the spheres of corporate and client-side finance, always guiding with a principal investor’s sharp acumen.
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