Working for an organization that offers employees “employee stock purchase plans” (ESPPs) can be an important gratuity to help you reach your financial goals. ESPPs are also a good way to save for retirement while diversifying your investment portfolio. If your company provides one, consider yourself lucky because around half of the public companies don’t.
Unfortunately, many employees do not fully utilize their ESPP because they are unsure how to do so. Here are some things you should know about the meaning of ESPP in practice and how to maximize its potential.
What Is A Employee Stock Purchase Plan? (ESPP)
An employee stock purchase plan (ESPP) is a voluntary savings program that allows employees to save money for their future or the future of their immediate family. The employee purchases company stock from the company and is allowed to do what they wish with it. This program is designed to help lower employee turnover rates by providing employees with incentives to stay and provide long-term value for the company.
Typically, you receive additional benefits that aren’t typically offered to the general public because the program is run by a third-party company but is endorsed by the company. You may purchase fractional shares, for example, with low transaction costs, or you may be able to purchase company stock for less than market value, which is a significant benefit for you.
Consider the following scenario: your employer provides you with a 25% discount on shares purchased through the ESPP. You’d pay $75 for $100 in stock. That would be a 33% immediate return. It would be difficult to outperform such a return.
Types Of The Employee Stock Purchase Plan (ESPP)
Employee stock purchase programs typically come in two forms: qualified and non-qualified plans.
1. Qualified Plans
An organizational-run qualifying plan requires shareholder approval to be put into effect. Additionally, there must be constraints on the maximum discount granted, the offering duration cannot exceed three years, and all qualified plan participants must have the same privileges.
2. Non-Qualified Plans
Non-qualified plans, on the other hand, are not subject to the same restrictions as qualified plans. In Fact, non-qualified plans have fewer favorable tax consequences.
Employee Stock Purchase Plan in action – How Does ESPP Work?
The rules and options of an ESPP might be confusing, which is one of the main reasons people are reluctant to sign up. Undoubtedly, an ESPP might be intimidating if you have little investment knowledge. Since every plan is unique, you must fully comprehend how everything operates.
When it comes to an ESPP, there are often three choices:
1. Stock congruent
Most of the time, ESPPs are set up in a matching format. Here, employees can buy business stock up to a predetermined percentage of their salaries. Your company will then match your purchase up to a predetermined limit.
For instance, as part of the ESPP, you can be permitted to invest up to 10% of your salary in company shares. Your company might match you by 10% to 50% in exchange. Any gift is essentially a raise for you.
2. Stock Reduction
This allows employees to buy company merchandise at a discount, such as 5–15% below the current market value, another well-liked ESPP option. Since there is less arithmetic, most people will find this a little easier to understand.
Some plans also offer a “look back option” that lets you purchase the stock based on its lowest price over a specific period. Consider that you have a 90-day look-back period available. The stock has increased by 10% more during the past 60 days. If you look back, you may purchase at a discounted rate.
3. Restricted Stock Unit (RSU)
Since restricted stock units (RSU) have no value when granted, they are a little more complicated. Although they are frequently given to employees, the vesting period, during which they become effective, is when their value materializes. Alternatively, the corporation may award RSUs if specific performance goals are satisfied.
If the company expands, RSUs might be pretty profitable. The cost to the employee is negligible, but you must continue working for the company until your shares vest; otherwise, you will not receive anything. Employees frequently leave their jobs as soon as their RSUs have vested.
Most businesses that provide an ESPP don’t let you choose between matching, discount, or restricted stock units. Although you can choose your contribution amount, you can’t choose between the discount and the matching. However, organizations that award RSUs could have more choices.
The Vesting Period For ESPP
Almost all employee stock purchase plans include a vesting term to motivate employees to stick with the company. Additionally, there may be various vesting periods, which initially seem absurd but make sense when comprehending them.
Vesting generally refers to the period before you fully own your shares. Consider the case where your ESPP matches stocks. You immediately own any stock you buy with your own money. The employer match, however, probably has a vesting time that could be one year.
That implies that until one year has elapsed, you do not own that employer match. You risk losing the match if you leave the organization before that time has passed. It would function on a first-in, first-out basis because most ESPPs buy monthly. If you decide to sell, the first shares you buy or get matched would be those sold first.
Some businesses may additionally enhance the value of the ESPP the longer you work there, even though it’s not legally vesting. After a year of service, you might receive a 5% match, a 10% match after two years, and a 15% match after three years.
The vesting time for restricted stock units may be considerably longer. As a new employee, you might be given 1,000 shares for $25 per share. Therefore, the potential value of your RSUs is $25,000. However, 200 shares may be subject to vesting at each anniversary. Accordingly, it would take five years for all of your shares to vest fully.
Always study the ESPP’s vesting regulations to know what will happen to your shares if you quit the company. RSUs frequently make it worthwhile to stay until your shares have fully vested.
ESPP and Taxes
Taxes may be due to both the buying and selling of shares and simply during the sale. The kind of taxes you owe depends on the kind of plan your employer offers and for tax-qualified ESPPs when you buy and sell your ESPP shares.
Suppose your employer offers a tax-qualified ESPP, in particular. In that case, you can be eligible for preferential tax treatment when you sell your shares if you do so more than a year after the date of purchase (when you receive the dividends) and more than two years after the date of the offering.
Like taxes on equity compensation, the tax situation of shares purchased through an ESPP can be complicated.
Pros of Employee Stock Purchase Plans
The benefits of taking part in an employee stock purchase plan are detailed below:
- Price on an organizational stock that are reduced.
- Employee stock purchase plans are straightforward and quick to sign up for.
- The interests of stockholders and employees are aligned.
- An increase in staff enthusiasm and effort to help the business prosper.
- An improvement in staff retention, loyalty, and morale.
- Participant pride in the organization is felt.
- The employees benefit when the business succeeds.
Cons of Employee Stock Purchase Plan
The drawbacks of taking part in an employee stock purchase plan are detailed below:
- Morale and motivation among employees may decline if the share price falls.
- It can be difficult to ensure the ESPP complies with security and tax legislation requirements.
- The administration of the stock purchase plan involves a significant number of HR activities.
- Setting up the plan involves legal, fiscal, and administrative considerations.
How much should I invest in a stock purchase plan?
Things have become challenging at this point. In general, I suggest that people maximize their ESPP as soon as possible to get the most benefit. I am aware that not everyone will be able to do this, so I do have a few recommendations.
Any amount will start the calendar moving. The value of many ESPPs rises with time. Before you start receiving the full advantage, it can take a few years. If money is tight right now, invest the bare minimum so you may gradually grow your profits.
If your line of employment is unstable, contribute that you feel comfortable with, but don’t make it your only investment. Particularly, instead of focusing mainly on your ESPP, you might want to continue to make contributions and invest in other things like index funds.
Although an employee stock purchase plan is an excellent way to increase wealth, it should not be your only investment. Maximize your contributions and consider selling a portion of your shares each year to diversify.
The ESPP’s sole purpose is to encourage employers to offer stock options to their employees. Keeping all these step-by-step instructions in mind, your ESPP can be an efficient way to transfer wealth and accrue a tax-free income.
Sagar Sridhar is a personal finance blogger from Canada. His genuine passion for personal finance coupled with his unique style of writing is what stands out. Professionally, he is a computer engineer, agile certified and has a master’s degree in Project Management. His writing has been featured or quoted in the leading Canadian publications such as Credit Canada and many other personal finance publications. While he is juggling between his day job and blogging, he is the main author on this blog and has miles to go before making the final pit stop.