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If you have access to an Employee Stock Purchase Plan (ESPP) at work, you may be unsure if it’s a good investment. You also might wonder how it’s taxed and whether to enroll in it. BWM Financial has experience helping clients at San Diego companies, including Qualcomm, Illumina, and ViaSat, make the most of their ESPP plans. In order to help, we’ve prepared this brief primer to help explain the basics of ESPP plans and to describe an example of one advanced strategy that we like.

What is an ESPP Plan? How does it work?

An ESPP is an employer benefit offered at some publicly traded companies that allows employees to purchase shares of their company’s stock at a discount. A typical ESPP program permits employees to enroll for a 12-month offering period. Participating employees choose to have a portion of their pay (up to 15%, or $25,000 per year) set aside by their company. Every six months, those funds are used to buy shares of the employer stock at a price below market value (typically a 15% discount). In some cases, an employer will offer a “lookback period” as an additional benefit. The employee still receives a 15% discount; however, the discount is applied to whichever is lower—either the value of the stock on the first day or the final day of the period.

How is an ESPP taxed? Is it pre- or post-tax?

Before you decide to max out your ESPP plan, it’s important to understand how an ESPP is generally taxed.* ESPP shares are post-tax. In other words, your employer stock is purchased with money on which you’ve already paid taxes. Taxes are only due when the ESPP is sold.

If you purchase shares and immediately sell them, expect to pay income taxes on the 15% discount, which is considered compensation by your employer. If you hold ESPP shares after purchase and they appreciate in value, you may pay capital gains taxes in addition to income tax on the discount. To qualify for favorable long-term capital gains taxes, your shares must be held more than two years after the start of the offering period, and more than one year after your purchase date. Although holding stock can result in favorable tax treatment, there are risks to consider. Read on to learn more. . . .

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Are ESPPs good investments?

These plans can be great investments if used correctly. Purchasing stock at a discount is certainly a valuable tool for accumulating wealth, but comes with investment risks you should consider. An ESPP plan with a 15% discount effectively yields an immediate 17.6% return on investment. To understand this return, consider a stock trading at $10 per share. An employee with access to an ESPP program with a 15% discount is able to purchase shares at $8.50. He or she can immediately sell shares for $10. This sale results in an immediate guaranteed profit of $1.50 per share on an investment of $8.50 per share of 17.6%. Using the maximum $25,000/year contribution to an ESPP plan, this translates to a $4,411 “gift” from one’s employer each year. Over a 30-year career, this employee benefit is worth $132,330!

Can you lose money on an ESPP?

As with any stock, the value of ESPP shares can drop or go away altogether, very quickly. A 15% decline in the stock price can easily wipe out the value received for participating in the plan. This risk of loss is especially important to remember when it comes to investing in your employer’s stock. Having a large portion of your nest egg and your income tied to the performance of one firm creates undue risk. At BWM Financial, we use sophisticated software to test clients’ financial plans so they know how much employer stock they can afford to own without risking their financial futures.

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!

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This content is developed from sources believed to be providing accurate information, and provided by BWM Financial. It may not be used for the purpose of avoiding any federal tax penalties. *BWM Financial and its financial advisors are not tax advisors.  Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.

Investment advice offered through Stratos Wealth Partners, Ltd., a Registered Investment Advisor DBA BWM Financial.  Investing involves substantial risk. BWM Financial and Stratos Wealth Partners do not make any guarantee or other promise as to any results that may be obtained from the Firm’s “letter”. While past performance may be analyzed in the Letter, past performance should not be considered indicative of future performance.  The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful. No reader should make any investment decision without first consulting his or her own personal financial advisor and conducting his or her own research and due diligence.