Should I participate? How much should I contribute?
It’s best to consider an ESPP contribution strategy in the context of one’s overall financial plan. Personal financial strategy often involves weighing a variety of interrelated investment, tax, budgetary, and behavioral considerations, which can be overwhelming to individuals who don’t have professional help and the right tools. Although everyone is different, we do see some common patterns.
Highly compensated employees at firms offering ESPP programs are often also awarded stock options and restricted stock as part of their compensation. If their company has done well, they may actually own too much of their company stock (as a percentage of their portfolio). Additional purchases of employer stock would further concentrate their investments and create unnecessary risks, if the stock fails to perform. They may still want to take advantage of their 15% ESPP discount and have the income to save. In addition, these people often have access to several types of tax-advantaged accounts. These include traditional or Roth retirement savings, Healthcare Savings Accounts, or Deferred Compensation plans that offer better long-term tax advantages than their ESPP program.
One strategy we like for these highly compensated clients involves a cycle of maximum ESPP contributions, simultaneous sales, high-basis shares, and immediate investment of proceeds in tax-advantaged accounts. The investor obtains the 17.6% immediate return on investment due to the ESPP discount. He or she sells an equal amount of previously held company stock in tandem with each ESPP purchase. The investor essentially replaces his or her employer stock holdings with stock purchased at a discount. Recently awarded shares from restricted stock units are often a great source of shares to sell upon each ESPP purchase. Recently vested restricted stock units (RSUs) are likely to have a high cost basis. They also don’t generate the additional income taxation associated with sales of ESPP shares. Proceeds from stock sales are then invested inside more tax-advantageous accounts to satisfy retirement savings, which would have otherwise been funded from a client’s earnings. If the usual savings strategies, such as normal 401(k) contributions, have been maximized already, proceeds from stock sales can be deployed elsewhere. “Super Backdoor Roth” savings, Healthcare Savings Accounts, or Deferred Compensation plans are common choices. These can provide either an additional income tax deduction, tax-deferred growth, tax-free growth, or a combination of benefits.
The net result of this transaction can be an immediate 17.6% return on investment, deferral of income taxes on the ESPP discount, and no added investment risk. If you’d like to discuss your ESPP program or your overall financial picture, we’d love to talk!