How to Get the Most From Your Employee Stock Purchase Plan

If you're fortunate enough to work for a company that offers an employee stock purchase plan (ESPP), then take note, because you have a wealth of opportunity in front of you.

An ESPP is a benefit used by publicly traded companies to help their employees save for their future. While the terms vary based on company policy, most plans allow participants to purchase stock through payroll deductions at a discounted rate. Purchases are made within these parameters:

• Offering period: Also known as an "enrollment period," when you'll accumulate payroll deductions to purchase company stock. A single offering period might begin on Jan. 1 and end on Dec. 31 of the same year.
• Purchase period: This is the time frame in which company shares are purchased on your behalf. A single offering period can include more than one purchase period lasting an equal amount of time -- every six months, for instance. In this case, the first purchase period might begin on Jan. 1 and end on June 30, which is also the stock purchase date. The second purchase period begins on July 1 and ends on Dec. 31, which is another purchase date. 

Working within these rules to make the most of your ESPP requires some planning. Take these tips into consideration as you invest.

Understand the perks

Not all ESPPs are created equal. To understand the perks, you need to know whether your plan is qualified or non-qualified. Qualified plans are recognized and regulated by the IRS. They allow your employer to offer company shares at a discounted rate, and earnings beyond that discount receive favorable taxation when you sell (as long as you meet the minimum holding requirements). Non-qualified plans aren't recognized by the IRS, and while they can function in the same way, you won't receive a lower tax rate on your earnings, which will eat into your long-term profits. You'll also be required to pay applicable taxes on the purchase date.

The majority of ESPPs are qualified, so for our purposes, we'll discuss qualified plans.

The primary benefit of ESPPs is the purchase discount, which tops out at 15% per share for the majority of qualified plans. In addition to per-share discounts, employers are finding new ways to encourage ESPP enrollment. According to a 2017 Stock & Option Solutions study, 39% of companies surveyed provided a "lookback" provision in their plans, which allows employees to purchase shares based on the price at the end or beginning of the offering period -- whenever share prices were lower.

For example, suppose you want to buy $15,000 in company stock through your ESPP. The share price at the beginning of the offering period (six months ago) was $30, while the current market value is $35.50. Your ESPP lookback provision allows you to lock in the $30 price, which buys you 500 shares rather than 423 shares at the current price.

The table below illustrates the potential savings of lookback provisions and employee discounts compared to market value price.

As you can see, that hefty discount allows you to buy far more stock and build your portfolio for less -- two things you can't afford to ignore.

Get creative with your earnings

Saving for retirement isn't the only way to use the funds in your ESPP. A recent Fidelity survey found that workers are cashing out their shares for more immediate needs, including:

• Paying down debt (34%)
• Buying or renovating a home (17%)
• Building an emergency fund (11%)
• Reinvesting ESPP proceeds into a different retirement savings vehicle (19%)

The liquidity of ESPP funds means the sky's the limit when it comes to how you use them, and using your earnings may be the wiser choice in the long run. For example, selling $10,000 in stock to remodel your kitchen might be more practical than taking out a personal loan with a 4.3% interest rate attached, which would drain $186 from your monthly budget, accrue more than $1,100 in interest over five years, and increase your debt-to-income ratio until the loan is repaid. Consider the benefits and drawbacks of each scenario to zero in on the wisest choice.

Work taxes in your favor

Reaping the greatest ESPP rewards relies largely on when you decide to sell your shares. Tax rules and timing are based on the stock's offering period and purchase periods. Taxes are assessed with these factors as benchmarks, and Uncle Sam's cut of your profits can vary significantly.

Although the stock price discount you receive from your employer is always considered additional compensation and taxed as ordinary income, your earnings beyond that fall into two categories: qualifying or disqualifying. Shares held for at least two years from the first day of the offering period and at least one year from the purchase date are considered a "qualifying disposition," which is taxed at a long-term capital gain rate of 15% for most taxpayers. If you sell your shares before then, earnings are considered a "disqualifying disposition" and are taxed as ordinary income.

Let's put these tax differences into context. Suppose you are in the 33% tax bracket and you invested $425 in an ESPP, discounted by 15% from $500 per share. The market surges, and you immediately sell the stock for $650. In this case, both your employee discount and earnings are taxed as ordinary income. Assuming you keep the stock until it meets qualifying disposition criteria, your earnings beyond the employee discount are taxed at 15%, because they are considered long-term capital gains. As you can see, the differences add up quickly.

Tax advantages are a major perk for ESPP participants. Make sure to cash in on lower rates whenever possible.

Set goals

It's hard to argue against discounts and low taxes, but even employee stock purchases should be made with goals in mind. Ask yourself a few questions to clarify your objectives:

• Would I buy this stock without an ESPP? The first consideration of any investment is sustainability. As with any other stock, you should research your company's historical returns and any upcoming developments that might affect the share price.
• How much should I contribute? It's vital to decide how much you can comfortably contribute to your plan. Most employers cap contributions based on a percentage of your salary, and the IRS limits annual ESPP contributions to $25,000. Keep in mind that although shares are highly liquid, you'll sacrifice a chunk of your earnings in taxes if you decide to sell too soon, which is why you should not use your ESPP as an emergency fund.
• How should I diversify? A balanced portfolio is priority No. 1, and it's a good idea to cash out or reinvest once the tax holding period swings in your favor, or if continued losses overshadow the tax benefits.
• What's my end-game? Every investment should have a goal. What are your plans for your ESPP earnings? Will they be used solely for retirement, or are you interested in buying a home, paying off debt, or even funding a vacation? Your answer might include all of the above, and it's prudent to taper your withdrawals to avoid diminishing returns.

Keep in mind that by relying on your employer for both wages and capital gains on your company shares, you're increasing your risk of financial losses in the event the company falls on hard times or goes belly-up. That's why your company shares should only account for a relatively small portion of your investing portfolio. However, when used responsibly, your ESPP can be a powerful savings vehicle. Don't miss the opportunity to profit.

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