Brennan McCarthy, CFP®
Questions about Employee Stock Purchase Plans (ESPPs) are one of the most common questions I hear from my clients. Taking advantage of company ESPPs, especially for young professionals, is one of the biggest missed opportunities I find in those financial plans.
1. What is an ESPP?
An ESPP is a benefit offered by some (typically public) companies that allows employees to purchase company stock at a discounted price, typically below the market price. This can be a great way for employees to build wealth over time, maintain liquidity, and use the tax code to their advantage—assuming the company's stock price goes up.
2. How does the ESPP work?
With an ESPP, employees typically have the option to contribute a portion of their salary (usually capped at 10%) to the plan each pay period. The company then withholds the contributions and uses them to purchase shares of company stock on behalf of the employee. The purchase price is usually set at a discount to the market price on the date the contributions are made or on the date the stock is purchased.
3. What are the benefits of participating in an ESPP?
There are several potential benefits to participating in an ESPP, including:
The ability to purchase company stock at a discount: This can be a great way to build wealth over time, especially if the company's stock price goes up. Although owning a single stock carries much more risk, it also has much higher return potential than a diversified portfolio.
The ESPP also provides much more flexibility and liquidity than a retirement account. The shares can be sold as soon as they are purchased (although the employee will benefit much more by holding them for at least a year).
A sense of ownership in the company: Participating in an ESPP can give employees a sense of ownership in the company, which can boost morale and engagement.
Tax advantages: By purchasing the stock at a discount and holding it for 12 months beyond the purchase point, employees can receive optimal long-term capital gains tax rates.
4. What are the risks of participating in an ESPP?
There are also some risks to consider when participating in an ESPP, including:
The stock price could go down: If the company's stock price falls by more than the discount offered, the employee would have been better off simply receiving their compensation in cash (instead of buying the stock).
Employees may be locked into their investment: Some ESPPs have restrictions on when employees can sell their shares, which means employees could be stuck with their investment even if the stock price goes down. Typically these restrictions aren’t longer than 1 year, but can be longer in some instances.
Concentration: There is significant risk holding a large amount of a single company’s stock—especially when the success of that company is also dependent on paying your salary.
5. What questions should I ask my company about the ESPP?
Before enrolling in an ESPP, it's important to ask your company some questions, such as:
What is the discount rate on the ESPP?
What are the contribution limits?
Are there any restrictions on when I can sell my shares?
What are the tax implications of participating in the ESPP?
The answers to these questions will help make more informed decisions about whether or not to participate in the company's ESPP.