If I offered to sell you $1.00 for $0.85, would you consider that a good deal? Of course!
Everyone loves free money and buying things at a discount. This is how an Employee Stock Purchase Plan (ESPP) works. It’s essentially free money. Like how a 401k match is referred to as free money (well, actually part of your compensation, but free sounds better), the stock discount in an ESPP is like free money. An ESPP is one of the better benefits of a compensation plan. If your company offers a stock purchase plan, it’s worth understanding the mechanics before deciding whether to take part.
In this post, I’ll cover the basics of employee stock purchase plans to help maximize your opportunity.
An ESPP plan is a form of compensation that companies use to incentivize and reward employees. For the employee, it’s an easy way to purchase company stock through payroll deductions. This means the money is taken from your paycheck to purchase company stock before it hits your bank account.
The best part is that employees can purchase stock at a discount from the price it’s trading in the stock market. Remember when I said free money? This discount is where the potential free money comes in. Many companies offer a 15% discount which is the maximum allowed. If your company offers a lower discount, it can still be attractive, especially if you have a lookback feature. The lookback feature can result in an even bigger discount on company shares, as discussed in the next section. Over time, consistently purchasing shares at a discount can compound into a lot of additional wealth.
If your employer offers a lookback feature, this sweetens the deal for your ESPP. A lookback allows the employee to buy shares at the lower of two price points — the stock price at the beginning of the end of the offer period. We will cover the offer period shortly. But, first, let’s look at a quick example of how the lookback works.
Your company has an ESPP with a 15% discount and lookback period. The stock price is $20 at the beginning of the offering period and $25 at the end of the offering period. When the purchase date comes around, you get to purchase the stock at 15% off of $20. This makes the purchase price $17.00. Since the stock is trading in the stock market at $25.00, you really received a discount of 32%!
As you can see, the lookback is a pretty powerful addition to an employee stock purchase plan. It ensures that if the price goes up during the offering period, you receive a discount on the lower share price, resulting in an even bigger discount! The lookback works the other way too. If the stock price declines during the offering period, you receive the lower price at the end of the period.
Now that we have covered the basic mechanics of a stock purchase plan, there are important dates to note. These dates will serve as an ESPP timeline which can be crucial in planning stock purchases and taxation.
Grant or enrollment date: This is the first day of the offering period. This date begins the clock for tax purposes and serves as the price point for the lookback feature for qualified plans. The specific grant date for an individual is when participation begins.
Enrollment period: The enrollment and offer period are the same for some companies, and others separate these periods. The enrollment period is when you can sign up for participation in the ESPP. If you happen to miss this, you have to wait until the next enrollment period.
Offering period. This is when payroll deductions are taken from your paycheck. These payroll deductions accumulate until the end of the offering period. This offering period is where the “lookback” feature will begin if your plan has one. Typically an offering period will be 12 to 24 months.
Purchase period: This is when You will purchase the stock. Some companies may have multiple purchase periods nestled within the offering period. For example, there might be a 12 month offering period that has two six-month purchase periods. Meaning the company will purchase your shares at the end of each six-month period.
Purchase date: This is the date your payroll deductions are deployed to purchase shares of company stock. This is usually the last day of the offering or purchase period. A long offering period may have multiple purchase dates. For example, a 12 month offering period may have two 6 month purchase dates (see visual below).
Ok, there are many moving parts when various dates and terms are involved, so I created this timeline graphic below. This is an example of a 12 month offering period with a purchase date of 6 months and 12 months.
I’m going to keep this section short and provide more detail on the taxation of ESPPs in a future post. A stock plan can be qualified, which is most common, or nonqualified. With a qualified ESPP, there is no tax until the shares are sold. For nonqualified ESPPs, the employer withholds tax when the stock is purchased.
Note: Although they use the same terminology, this is not confused with qualified retirement accounts that are tax-deferred.
Participating in an ESPP can be a huge benefit to your financial strategy. With proactive planning, these plans can accelerate your path to wealth. While the discounted purchase might be “free” money, it’s important to consider all factors. For example, it would help if you thought about how the company stock fits into your overall plan, how to manage the tax bill, and the concentration risk associated with single-stock positions. Overall, an ESPP should be high on your list. If you need help getting the most out of your employee stock purchase plan, let’s chat!