For most people, the goal of being financially independent mostly stems from not being solely reliant on an employer for money. It requires setting up additional income streams outside of just your full-time job. However, I still enjoy my tech job in Silicon Valley because I get to work on interesting products that solve problems for people using technology. That is why I consider myself to be “Barista FIRE” because I still take advantage of my employer’s benefits. My employer subsidizes my health insurance cost for my family, which costs $20,576 according to Kaiser Family Foundation (KFF).
Another great benefit of having an employer is the Employee Share Purchase Plan (ESPP). Part of my salary compensation is paid in RSUs but another benefit from working for a publicly-traded company is the ESPP.
In this post, I will talk in detail about the Employee Share Purchase Plan and how it works. It can become a powerful tool in helping you achieve FIRE earlier and should always be taken advantage of.
An Employee Stock Purchase Plan (ESPP) is an employer-provided benefit for employees to purchase company stock at a discounted price through accumulated payroll deductions. If you work for an employer that offers ESPP, I would highly recommend participating because you essentially always profit the discount amount (or more) upon selling the shares immediately.
ESPP for Startups
Previously ESPP was only available for employees of publicly traded companies however, I have seen start-ups now offering ESPP for private shares that are priced from the latest funding valuation. For those that work at a start-up, be aware that your ESPP shares are worthless until a liquidation event occurs such as an initial public offering (IPO) or your startup is acquired.
How does an ESPP Work
Employees who choose to participate in ESPP must determine a percentage (1% to 10%) of after-tax payroll deductions to make towards ESPP. The ESPP deductions are accumulated between the offering date and the purchase date called the Offering Period. On the purchase date, the company uses the employee’s accumulated funds to purchase company stock at a discounted price of up to 15% depending on the employer. The purchase price for the company stock is determined by comparing the price from the first day and last day of the Offering Period. These two stock prices are compared where the lower stock price is offered as the purchase price.
Is ESPP a Good Investment
If you work for an employer that offers ESPP, I would highly recommend participating because you essentially always profit the discount amount (or more) upon selling the shares immediately. There are only two scenarios that can occur upon selling the shares immediately from ESPP. I will outline them with the following scenarios and illustrations.
Let’s pretend that Sam is a Software Engineer and he contributes 10% of his after-tax salary to his employer’s ESPP. His employer, Big Public Company outlines the following details for ESPP:
- ESPP Offering Period is 6-months between January 1st and June 30th and July 1st and December 31st.
- Big Public Company ESPP discount is 15%.
- Sam’s base salary is $120,000 and he elects to contribute 10% to ESPP.
- Using an estimated 35% payroll taxes, Sam accumulates $3,900 in ESPP payroll deductions.
Scenario 1: ESPP where Purchase Price is from first day of Offering Period
- Big Public Company stock price is $90 per share on January 1st.
- Big Public Company stock price is $100 per share on June 30th.
- Therefore the Purchase Price from the Offering Period will be $90 subtract 15% discount which becomes $76.50 per share.
- Sam is able to purchase 50 shares of Big Public Company stock on June 30th.
- Sam decides to sell immediately, therefore netting an ROI of 28%.
Scenario 2: ESPP where Purchase Price is from last day of Offering Period
- Big Public Company stock price is $100 per share on June 1st.
- Big Public Company stock price is $95 per share on December 31st.
- Therefore the Purchase Price from the Offering Period will be $95 subtract 15% discount which becomes $80.75 per share.
- Sam is able to purchase 48 shares of Big Public Company stock on December 31st.
- Sam decides to sell immediately, therefore netting an ROI of 15%.
Should I Max Out my ESPP
Every personal situation is different so you will have to determine how much after-tax payroll deduction you can financially endure for ESPP. In other words, can your lifestyle expenses handle the cash flow reduction that will be allocated towards ESPP until the offering period is over. In my honest opinion (IMHO), I would recommend maxing out ESPP because of the ROI being 15% or greater. It is essentially a guaranteed investment return if you sell the shares immediately. The ESPP is a great employer-benefit to take advantage of and can become a powerful tool in helping you achieve FIRE earlier.
Should I sell ESPP Immediately
If you work for an employer that offers ESPP, I would highly recommend participating because you essentially always profit the discount amount (or more) upon selling the shares immediately. If you sell the ESPP shares immediately, you are locking in the profits where only two scenarios can occur that I explained earlier in this post. The profits realized from selling ESPP immediately will now be subject to ordinary income tax.
Related Post: Are RSUs taxed twice?
How is ESPP Taxed
The Employee Share Purchase Program is a great benefit to take advantage of if your employer offers it. This section will describe the taxes related to ESPP that are good to be aware of. Like with RSUs, there are ESPP situations that result in Short-Term Capital Gains or Long-Term Capital Gains. Unique to ESPP is understanding qualifying dispositions which are subject to lower taxes than disqualifying dispositions.
- ESPP Discount
- ESPP Short-Term Capital Gain Disqualifying Disposition
- ESPP Long-Term Capital Gain Disqualifying Disposition
- ESPP Long-Term Capital Gain Qualifying Disposition
ESPP Discount Compensation Income
The ESPP stock shares you are purchasing is with your own after-tax money similar to if you had bought them on the open market. The key difference is that ESPP stock shares are purchased at a discount of up to 15% provided by your employer. The employer discount shows up on your W2 as additional compensation where it is subject to ordinary income tax. The employer discount multiplied by the amount of stock purchased is sometimes referred to as a bargain element when you file your taxes.
ESPP Short-Term Capital Gain Disqualifying Disposition
Selling the ESPP stock less then a year after the purchase date results in a Short-Term Capital Gain.
Selling the ESPP stock more than two years after the offering period (grant) start date is a qualifying disposition.
Short-Term Capital Gains are paid for any capital gains profits that are sold where the assets are held for less than 1-year after the exercise purchase date. Short-Term Capital Gains income is subject to the mandatory supplemental wage withholding taxes that include:
- Federal income tax at the flat supplemental wage rate (22% in 2019)
- Social Security (up to the yearly maximum) and Medicare
- State and local taxes (where applicable)
ESPP Long-Term Capital Gain Disqualifying Disposition
Selling the ESPP stock more then a year after the purchase date results in a Long-Term Capital Gain.
Selling the ESPP stock more than two years after the offering period (grant) start date is a qualifying disposition.
Long-Term Capital Gains are paid for any capital gains profits that are sold where the assets are held for greater than 1-year after the exercise purchase date. Long-Term Capital Gains are subject to 15% tax if your income is between
- $39,376 to $434,550 (filing Single)
- or $78,751 to $488,850 (filing Jointly Married)
- Single filers who make less than $39,376 pay 0% Long-Term Capital Gains tax.
- Jointly Married filers who less than $78,751 pay 0% Long-Term Capital Gains tax.
ESPP Long-Term Capital Gain Qualifying Disposition
Selling the ESPP stock more than a year after the purchase date results in a Long-Term Capital Gain.
Selling the ESPP stock more than two years after the offering period (grant) start date is a qualifying disposition.
Gains or losses realized in a qualifying disposition is taxed at a lower rate than a disqualifying disposition. For a qualifying disposition, the compensation income is taken from the lesser of two numbers:
- The difference between the market price and the discount price calculated on the grant date.
- The difference between the sales price and the purchase price.
For example, going back to Sam the Software Engineer Scenario 1 above where the additional variables are the following:
- Today is Jan 2nd (2-years after offering period start date)
- Purchase Price from Scenario 1: $76.50
- Fair Market Value: $110 (Big Public Company stock)
Therefore the calculations for qualifying disposition would be:
- $90 – $76.50 = $13.50 x 50 shares = $675 (bargain element)
- $110 – $76.50 = $33.50 x 50 shares = $1,675
The qualifying disposition allows you to pay tax for the lesser of the two calculations. In this example, the amount of $675 is subject to ordinary income tax as additional compensation. While the Long-Term Capital Gain amount would be ($110 – $76.50 + $13.50) x 50 shares = $2,350 which is subject to 15% tax.
Can you Lose Money on ESPP
With any investment, you can actually lose money on ESPP which is why I recommend selling the shares immediately so you avoid such a scenario. The ESPP employer discount shows up on your W2 as additional compensation where it is subject to ordinary income tax. This tax is paid when you decide to sell your ESPP shares even for a capital loss. Now, imagine a scenario where your qualifying disposition is worth less than what you paid for it. This scenario would happen if the stock dropped in price below the discounted share price because you were holding your position instead of selling immediately.
For example, going back to Sam the Software Engineer Scenario 1 above where the additional variables are the following:
- Today is Jan 2nd (2-years after offering period start date)
- Purchase Price from Scenario 1: $76.50
- Fair Market Value: $2 (Big Public Company stock)
Therefore the calculations for qualifying disposition would be:
- $90 – $76.50 = $13.50 x 50 shares = $675 (bargain element)
- $2 – $76.50 = (-$74.50) x 50 shares = (-$3,725)
For this example, the amount of $675 is subject to ordinary income tax as additional compensation. While the capital loss amount would be ($2 – $76.50 + $13.50) x 50 shares = $3,050 which can be used to reduce your Adjusted Gross Income (AGI) where you can claim losses up to $3,000 per year. In my example, Sam can claim $3,000 on his taxes this year and carry forward the remaining $50 loss claim to next year’s taxes.
My ESPP Recommendations
To summarize, if you work for an employer that offers ESPP, I would highly recommend participating because you essentially always profit the discount amount (or more) upon selling the shares immediately. Avoid trying to hold ESPP shares because you want it to be a qualifying disposition sale. There is a risk of losing money on ESPP in the scenario where the stock price sold is below the discounted price. Better to avoid encountering such a scenario by selling immediately to lock in the profit and just pay the ordinary income tax on your sale.
Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services.
