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ESPPs: Basics

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Are You Taking Full Advantage Of Your Company's Employee Stock Purchase Plan?

Sandra Sussman

Your company may offer you an attractive benefit that is even better than stock options. An employee stock purchase plan (ESPP) enables you to purchase company stock often at a discount from the market price. In the most generous plans, you buy the stock with payroll deductions of up to 15% of your paycheck (you decide how much within this range, with a $25,000 annual maximum for tax-qualified plans).

An ESPP offers a way to purchase company stock easily and on favorable terms, giving you (not just top executives) an opportunity to share the potential growth of your company's stock. Fitting ESPPs into your financial plan is worth trying (see a related article).

A Great Deal


Section 423 ESPPs are almost too good to be true.

Although the mechanics of ESPPs vary, plans that meet the conditions under Section 423 of the Internal Revenue Code generally offer the best deal for employees. What makes a Section 423 plan so appealing is the double-barreled "goodie" that comes from a discounted price along with something called a "lookback" feature. Unfortunately, many employees don't fully understand how the discount and lookback features work (see the FAQs in ESPPs: Basics). As a result, they might pass up a deal that is almost too good to be true. Even with the accounting change that has made it more "costly" for companies to offer discounts with lookbacks, ESPPs remain an attractive benefit for tax reasons (see how companies are responding to ESPP expensing).

The Discount—A Built-In Profit Of At Least 17.6% (Even In Down Markets)—With Potential For Much More

The biggest discount the IRS allows is 15%, but (here's the kicker) it can be much greater if your ESPP has a lookback feature: your purchase price is 15% off the market price at either the beginning or the end of the purchase period, whichever is lower, and a typical plan purchase period runs for six months.

Example: The stock price is $10 at the beginning of the purchase period and goes up to $20 at the end. Your purchase price is just $8.50—a hefty 135% return! Even if the price never moves from $10, the 15% discount results in an $8.50 purchase price, giving you a 17.6% return ($10 - $8.50 = $1.50; $1.50/$8.50 = 17.6%). Even if the price drops to, say, $5 at the end of the purchase period, your purchase price will be $4.25, so you will still get a 17.6% return ($5 - $4.25 = $.75; $.75/$4.25 = 17.6%)! (See a related FAQ for an example with a smaller discount and an example with no lookback.)
Taxes Deferred


A potential tax benefit exists in Section 423 ESPPs if you hold shares at least one year from purchase and two years from the start of the purchase period.

As for taxes, although the money deducted from your paycheck will be taxed like the rest of your salary (i.e., post-tax), you have potential tax benefits under Section 423 ESPPs if you are willing to hold the shares for at least one year from the purchase date and two years from the beginning of the purchase period: any tax liability is deferred until the stock is sold, and only the purchase price discount (or your actual gain on sale, if lower) will be taxed at ordinary income rates, with the rest of your gain as long-term capital gain. For plans with a lookback feature, the discount that is subject to ordinary income tax is computed as of the first day of the purchase period (see ESPPs: Taxes Advanced for details and examples).

You Can Opt Out And Get Your Money Back!

At any time up to the purchase date, ESPPs typically allow you to withdraw all of your money from accumulated payroll deductions instead of purchasing the shares (see ESPPs: Advanced). Check your company's procedures for doing this during an ongoing offering and for re-enrolling later in the ESPP. In short, you have absolutely nothing to lose and much to gain by participating in an ESPP!

How To Reap The Full Benefits

Investing in any company's stock is risky: we all know that. Markets go up and down. But with risks come rewards, and hanging on for the long term (as opposed to selling the stock immediately on the purchase date for a quick gain) is, more often than not, rewarding. You probably won't get rich overnight by participating in a company ESPP. Over time, however, the gains can be attractive.

Chart Past Performance


Over time, the gains can be attractive.

Perhaps a better way to understand the value of a long-term investment in your company's stock is looking at its past performance. While this is no guarantee of future performance, charting the stock price's course over the past five years or so may give you some idea of what you have been missing by not participating. In the long-running bull market of the 1990s, ESPP participants who stuck with it probably did well.

Dollar Cost Averaging

Even dips in the stock price will work in your favor. The great thing about an ESPP is that it encourages regular investing of a specific amount of money, which allows you to take advantage of something referred to as "dollar cost averaging." That is: the lower the price, the more shares you can purchase with your accumulated funds at the end of the purchase period and vice versa. Understanding this can make the dips in the company's stock price much easier to tolerate because the more shares you own the greater the upside potential as the stock price rises.

Example: You have $5,000 deducted from your pay to invest at the end of every offering period. The price at the beginning of one period was $10 but dropped to $5 by the purchase date. With your 15% discount, you purchase 1,176 shares at $4.25 per share (1,176 x $4.25 = $5,000). The next offering period begins on the following day, when the stock is still at $5, and ends when the stock is $10 per share. Again, with the lookback feature and the discount, you purchase another 1,176 shares at $4.25 per share. When the share price reaches, say, $20, the total of 2,352 shares you purchased for $10,000 will have already earned you a pre-tax gain of $37,044 ($20 - $4.25 = $15.75; $15.75 x 2,352 = $37,044). Now that's putting your money to work!

Dividends

Keep in mind too that if your company pays dividends the deal gets even better. You will receive a check for the dividend amount each quarter for the stock you hold. If your company has a dividend reinvestment plan, you have yet another opportunity to take advantage of dollar cost averaging to buy even more shares of company stock.

Nonqualified Plans: Convenient And Inexpensive Stock Purchases

The above discussion applies only to Section 423 ESPPs (and even some Section 423 ESPPs may not offer the full 15% discount or the lookback feature). You may also have an attractive ESPP with a discount or match that is not structured to meet the requirements of IRC Section 423 (see a related FAQ). At the other end of the spectrum are simple non-Section 423 payroll deduction plans that allow you to accumulate funds to purchase company stock at the end of, say, the pay period, or on a monthly basis. No bells or whistles are attached to these plans, and typically they offer no significant discounts off the purchase price. Rather, the appeal of plain payroll deductions is the ease with which you can regularly purchase shares. Plus, the company usually picks up any commissions incurred in the purchase transactions. (Of course, these attractive features are part of all Section 423 ESPPs as well.)

No Excuses

Bottom line: few investments start out with a minimum 17.6% gain. So don't forget to take full advantage of your company's ESPP. It offers an easy, efficient, painless, and rewarding way to pursue a disciplined savings plan and build your financial resources for the long term.

Sandra Sussman is a former Executive Director of the National Association of Stock Plan Professionals (www.naspp.com). She is a member of the NASPP, GEO, WorldatWork, and the Society of Corporate Secretaries and Governance Professionals. In addition, she serves on the Advisory Board of myStockOptions.com.


People who read this article also read:
Fundamentals Of Employee Stock Purchase Plans (Part 2): Design Limitations And Enrollment Procedures
Fundamentals Of Employee Stock Purchase Plans (Part 1): Basic Structure And Terms
Fundamentals Of Employee Stock Purchase Plans (Part 3): Tax Treatment Of Your Purchases And Sales
Employee Stock Purchase Plans & Your Financial Planning (Part 1)