Making the Most of Your Employee Stock Purchase Plan (ESPP): A Guide to Building Wealth with Your Company’s Stock

Employee Stock Purchase Plans, or ESPPs, offer employees a unique opportunity to buy their company’s stock at a discounted price, giving them a direct stake in the company’s success. ESPPs are especially popular in tech and other high-growth industries, where stock value can increase over time, allowing employees to benefit from both the discount and the company’s growth.

In this guide, we’ll explain how ESPPs work, why they’re valuable, the tax implications, and how to make ESPPs part of a well-rounded financial strategy. ESPPs don’t typically trigger the Alternative Minimum Tax (AMT), but we’ll cover all the important tax details to help you maximize your ESPP’s value.

What is an ESPP?

An Employee Stock Purchase Plan (ESPP) is a benefit that allows employees to purchase company stock at a discount. ESPPs usually work on a contribution period or offering period basis, where employees can choose to set aside a portion of their paycheck to be used for buying company shares.

Discounted Purchase Price

One of the main attractions of an ESPP is the discount, typically around 10 to 15% off the market price. This discount provides immediate value to employees, as it allows them to buy shares at a price lower than the stock’s actual trading value.

Lookback Provision

Many ESPPs have a lookback provision, which allows employees to buy shares at the lower price between the start of the offering period and the purchase date. The lookback feature adds to the discount’s potential, especially if the stock price rises over time.

Example:
Suppose your company’s ESPP offers a 15% discount with a lookback. At the start of the offering period, the stock price is $40, but by the end, it has risen to $50. Thanks to the lookback, you can buy shares at a 15% discount on the lower price of $40, which means you pay $34 per share.

How ESPPs Work

Enrollment and Contribution

To participate in an ESPP, you enroll during an enrollment period, choosing a percentage of your salary (usually up to 10-15%) to contribute. This amount is withheld from each paycheck during the offering period.

Example:
Let’s say you make $60,000 per year and decide to contribute 10% of your salary, or $6,000, to the ESPP. A portion of this amount is set aside from each paycheck. If your company has two purchase dates a year, you’ll have $3,000 saved up by each purchase date to buy company shares.

Purchase Date

On the purchase date, your contributions are used to buy company stock at the discounted price. Some companies have multiple purchase dates in one offering period, which means employees may buy shares twice a year.

Vesting and Holding Periods

Unlike other stock options, ESPPs generally do not have a vesting schedule, so employees own the shares outright upon purchase. However, holding periods are important to consider for tax purposes, which we’ll cover in detail.

Truly Aligned Insight:
We believe ESPPs can offer a straightforward path to building wealth with fewer restrictions than other stock options. By consistently participating, employees can steadily accumulate shares, but it’s also crucial to manage concentration risk and have a diversified portfolio.1

Tax Implications of ESPPs

One of the most important aspects of ESPPs is understanding the tax treatment. ESPPs are not taxed at purchase; rather, taxes come into play when you sell the shares.

Qualifying vs. Disqualifying Dispositions

Tax treatment depends on whether your sale is a qualifying disposition or a disqualifying disposition:

1. Qualifying Disposition: A sale qualifies if you hold the shares for at least two years from the offering period’s start date and one year from the purchase date. Qualifying dispositions are taxed at favorable capital gains rates.
2. Disqualifying Disposition: If you sell the shares before meeting the holding period requirements, it’s a disqualifying disposition, and your profit is taxed at ordinary income rates.

Tax Breakdown

• Qualifying Disposition: In a qualifying disposition, the difference between the purchase price and the fair market value on the purchase date is taxed as ordinary income, while any additional profit is taxed as a capital gain.

Example of a Qualifying Disposition:
Let’s say you buy shares at $34 (discounted from the $40 market price), hold them for over two years, and sell them at $60. The $6 discount ($40 – $34) per share is taxed as ordinary income, while the remaining gain from $40 to $60 is taxed as a long-term capital gain.

• Disqualifying Disposition: In a disqualifying disposition, the difference between the discounted price you paid and the fair market value at the purchase date is taxed as ordinary income. Any additional gain beyond that is treated as a capital gain, but if sold within a year, it’s subject to short-term capital gains tax.

Example of a Disqualifying Disposition:
Suppose you buy shares at $34 and sell them within a year at $60. The $6 discount is taxed as ordinary income, and the gain from $34 to $60 is taxed as short-term capital gains, which are typically taxed at the same rate as ordinary income.

Truly Aligned Insight:
With tax implications in mind, our philosophy is to align ESPP decisions with your long-term financial goals. Holding for qualifying dispositions can provide tax savings, but the best decision often depends on your need for cash flow, tax bracket, and market outlook.

Should You Hold or Sell Your ESPP Shares?

Deciding when to sell ESPP shares depends on your personal financial goals, tax situation, and view of the company’s future.

Reasons to Sell Immediately

1. Reduce Concentration Risk: Holding a significant portion of your wealth in company stock can be risky if the stock’s value declines. Selling immediately can help you diversify.
2. Meet Financial Goals: If you have near-term financial goals like buying a vacation home or paying for your kid’s college, selling ESPP shares right after purchase can provide needed cash.

Reasons to Hold for the Long Term

1. Belief in the Company’s Growth: If you believe in the company’s potential, holding the shares for the long term may lead to greater gains.
2. Tax Efficiency: Holding for a qualifying disposition allows you to benefit from long-term capital gains tax rates, which are generally lower than ordinary income tax rates.

Example Decision:
If you buy shares at $34 and the stock’s value steadily rises, holding the shares for over a year can help you capture long-term capital gains tax rates. But if the stock’s price fluctuates and you’re uncertain, selling soon after purchase can help mitigate risk.

Truly Aligned Insight:
At Truly Aligned, we see ESPPs as a blend of immediate and future wealth-building opportunities. Diversification is key. We recommend balancing company stock with other investments to support your broader financial goals while allowing room for growth.

Frequently Asked Questions About ESPPs

What happens if I leave my company while participating in an ESPP?

Typically, if you leave the company during the offering period, your contributions are returned to you, and you won’t purchase shares on the next purchase date. Shares you’ve already purchased are yours to keep.

Should I contribute the maximum amount to my ESPP?

Contributing the maximum can be valuable if you believe in the company’s stock potential and can afford to set aside the funds. However, we recommend balancing ESPP contributions with other investment and cash flow needs.

Can I use ESPPs to save for retirement?

Yes! ESPPs can be a valuable part of retirement planning. Holding shares for qualifying dispositions can help you benefit from capital gains rates, allowing your wealth to grow over time.

Truly Aligned’s Take on ESPPs

At Truly Aligned, we view ESPPs as an accessible way to build wealth and participate in your company’s success. Whether you’re using ESPPs for short-term gains or long-term growth, aligning these decisions with your unique goals can amplify their value.

Our approach centers on tax-efficient planning, balanced diversification, and a strategy that considers both immediate and future needs. By making thoughtful choices around ESPPs, you can build a financial foundation that reflects your vision, joy, and aspirations.

1There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

Want to learn more about other types of stock compensation? Read Truly Align’s Navigating Stock Compensation: A Comprehensive Guide to ESPPs, ISOs, RSUs, and NSOs.