Should I Participate in an Employee Stock Purchase Plan (ESPP)?
You may be missing out on more 'free money'
Disclaimer: I am not a financial advisor, accountant, or tax expert, nor do I claim to be. The information in this post is not a substitute for financial advice from a professional who is aware of the facts and circumstances of your individual situation. This is purely my own experience trying to learn personal finance and build a better future.
The term ‘free money’ is most commonly applied to the 401k match that many employers offer. This is because the employee is guaranteed a 100% return on that contribution immediately. Obviously, it’s foolish to pass this up. Even if you’re not a fan of the 401k, a 100% return is undeniable. However, there’s another lesser-known way to go after some more ‘free money’ once you’ve already checked the box for the 401k match, the ESPP.
Now, ESPPs vary and I only have personal experience with 1 ESPP. But in general, an ESPP allows an employee to take after-tax paycheck deductions which will, at the end of the offering period, be invested in company stock at a discount. This discount can be as good as 15%, but any discount presents a great opportunity. Some companies even offer a lookback provision that allows you to get the lower of the offering date price and the purchase date price. My ESPP deposits the shares into my individual brokerage account after a brief settlement period (usually ~3 days).
ESPP Benefits
The benefits of an ESPP are straightforward, you are able to use a portion of your salary to purchase your company’s stock at a discount to the market value. You may even be able to leverage a lookback provision. Let’s look at an example so we can understand why this can be such a good deal.
In this example, the ESPP has a 12-month offering period and a 10% discount with no lookback. This company allows up to 10% of an employee’s salary to go towards the ESPP. Our employee Andy enrolls in the program at 10% of his salary. For simplicity, we will say Andy makes 120k, so his bimonthly paychecks will have after-tax deductions of $500 for the whole year.
(120k salary / 24 pay periods) x 10% contributions = $500 per paycheck
Andy’s contributions balloon to $12,000 on the year, which are then used to buy the stock at a 10% discount. Let’s say the stock was $100, so Andy can buy $12,000 worth at $90 a share. That lets Andy come away with 133 shares and $30 left over.
Here’s where things get fun, all 133 shares are worth $100, so Andy can just sell them ASAP for $13,300 if he wants! Andy does owe income tax on the $1,300 extra he made since he did not wait until this became a ‘Qualified Disposition’, but he was essentially paid $1,300 extra by participating in the program.
It’s not a 100% return, and we ignored the fact that the stock price may change between the purchase date price and when Andy is able to sell, but participating in the ESPP can be a low-risk way to increase your income. Worth thinking about, Andy’s dollars were tied up for an average of 6 months while he was able to make a 10% return (before taxes). That’s a 20% annualized return, and it’s a much better bet than putting that money into the market instead.
ESPP Risks
The biggest risk IMHO of an ESPP is that it doesn’t fit into the budget. Remember, these are after-tax paycheck deductions. If you don’t have a budget, are still working on building up an emergency fund, or aren’t leveraging the 401k match, the ESPP is a bridge too far. Only move on to the ESPP once you’ve established a stable budget and are confident you can go without the take-home pay until the end of the offering period (at the earliest).
Also, make sure you understand that Andy’s paychecks would not be $5,000 every two weeks, we haven’t discussed taxes since they vary, but he will likely come home with around $3,000, so with the ESPP it’s now only $2,500 per paycheck. Still not bad, but that $500 can be a much bigger chunk than you realize if you don’t have transparency around your budget.
Then again, there’s always the risk that the stock price swings between the purchase price and when the shares settle so you can sell them. In theory, we could lose money in an ESPP if the price plummets by more than our discount. On the other hand, the price could also skyrocket in that time period, resulting in an even higher profit! So the settlement period risk is quite low in comparison, unless your company is particularly volatile and you think the stock could swing by the discount percentage during the settlement period.
Finally, who said you have to sell your shares?! You might prefer to hang onto the stock if you’re confident in the future of the company. This is a huge risk because your job and a lot of your portfolio will be highly correlated. But hey, high risk = high reward 🤷♂️ I don’t personally like this strategy, but it’s worked out for others in the past.
If you do choose to hold the stock, you can also wait until at least a year after purchase and 2 years from offering to get capital gains treatment as opposed to income tax, just make sure you check your plan’s details on qualified dispositions. A little bonus for the diamond hands 💎
Conclusion
The ESPP is a great tool to maximize income once you’ve squared away retirement savings and your budget. If you can afford it, it’s the next closest thing to free money. I recently started participating to stretch my dollars a little further as I save for big life events. I could put that money in a HYSA, but I’ll just sell ASAP on settlement and then put it in my HYSA or even my (Backdoor) Roth IRA. That way I’ll get a better return on my money in all likelihood.
Ultimately, it’s a personal decision. I’m comfortable taking a small amount of risk because I know I need to save up some cashflow and the offering period is sufficiently small. I am simultaneously working towards maxing my retirement contributions (401k, HSA, Roth IRA), but at this point in my life I will need that money, so I want to make it work for me as best I can. If I didn’t need it semi-liquid (within 1-2 years), I would probably prioritize maxing the 401k first and then attack the ESPP. But for me, I decided to incrementally work on both for now. It’s just hard to beat that sweet 20% annualized once you see it on paper 🤩
Think I botched something? Leave me a comment below!