What Is an ESPP and Should I Participate in One?

Some companies allow their employees to buy company stock through something known as an Employee Stock Purchase Plan, or ESPP. Employee stock purchase plans allow employees to buy company stock at a discount. This can generate gains for employees when the stock is sold.

Joining an ESPP is one way to increase your overall compensation.

In this article, we’ll explain how ESPPs work and explain why you should participate in an ESPP if you can afford to cover the temporary loss of income.

Table of Contents
  1. What Is an Employee Stock Purchase Plan (ESPP)?
  2. How Does an ESPP Work?
    1. ESPP Example
  3. Qualified vs. Non-qualified ESPPs
  4. The Tax Implications of an ESPP
  5. Capital Gains Tax on Qualified vs. Non-qualified Plans
  6. Should You Participate in an ESPP?
  7. FAQs
  8. Bottom Line

What Is an Employee Stock Purchase Plan (ESPP)?

An ESPP is a benefit program provided by some publicly traded companies. It allows their employees to purchase company stock at a discount. This discount can be as high as 15%.

The company will occasionally make discounted stock available to employees, generally every six months.

Employees contribute up to 10% of their gross pay via payroll deductions, up to $25,000 per year. This works similarly to 401(k) contributions. With each paycheck, a predetermined amount is withheld and placed into an account for use when stock is released for sale.

Employers use ESPPs as a way to encourage employees to purchase company stock. It serves to bolster the price of the stock and gives employees an incentive to work harder for the company since they will be partial owners of the business.

Once an employee purchases stock under the plan, they can choose to hold onto the shares as a long-term investment or sell for an immediate gain.

How Does an ESPP Work?

The employer can choose when and how often to release stock for sale in the ESPP. The employer will announce that stocks will be available on a certain date and payroll deductions will begin for the enrolled employees. This period of time is called the “offering period”.

Funds will build up during the offering period, and when the purchase date arrives, the stock will be automatically purchased with the funds from the account. However, the employee is not required to purchase stock and can keep the funds in the plan for future offerings. The money can also be withdrawn at any time.

The price paid for the stock can be set at either the date the offering is made, the date of purchase, or the lower of the two, as determined by the employer.

Once purchased, it’s up to the employee to decide if they want to hold it or sell it. Some plans allow for immediate sale, others require a set holding period.

Unlike an employer-sponsored retirement plan, contributions made to an ESPP are not tax-deductible, even though the contribution percentage is calculated based on pretax earnings. 

Related: ESOP VS. ESPP

ESPP Example

ABC, Inc. announces on January 1st that company stock will be available for purchases on March 31st. The stock will be offered at a 15% discount of the market value on March 31st. Thus beginning the offer period.

Enrolled employees begin to have their predetermined withholdings taken from their paychecks and set aside to purchase the company stock.

On March 31st, the stock is selling for $100. The money is taken from the employees ESPP accounts and stock is purchased at $85 per share.

If the plan allows, the employee can then immediately sell the stock for $100 each, earning a 17.6% profit.

Related: ESOP vs ESPP: What You Need to Know

Qualified vs. Non-qualified ESPPs

There are two general classifications of ESPPs, qualified and non-qualified.

A qualified ESPP has some tax benefits. It also requires the approval of company shareholders, the offering period must be three years or less, and the maximum share price is limited.

Non-qualified ESPPs have fewer restrictions but do not have the tax advantages offered under qualified plans.

The Tax Implications of an ESPP

As mentioned, contributions made to a plan are made after taxes. Consider this when determining what percentage of your income will go to a plan. The percentage you elect will be pre-tax, but the contribution will come out after taxes.

For example, if you earn $100,000 and elect to contribute $10% of your income, then $10,000 will be deducted from your after-tax income.

If the plan is non-qualified, you will be required to pay tax on the difference between the stock’s fair market value and the actual price you paid for it in the year you purchased the stock.

If the market price of a stock is $100 at the time of purchase, and the employee buys it for $85 (15% discount) – the $15 per share will become immediately taxable. If you purchase ten shares, the taxable gain will be $150 ($15 x 10 shares).

Under a qualified ESPP, the discount is recognized as taxable income in the year the stock is sold, rather than when it was purchased.

Under a non-qualified plan, your employer will be required to withhold applicable federal income tax on the dollar amount of the discount. There is no such withholding requirement on qualified plans.

In both cases, the discount is taxed as ordinary income, much like wages.

Capital Gains Tax on Qualified vs. Non-qualified Plans

Whether your ESPP is qualified or non-qualified, the sale of the stock purchased through the plan can generate either a capital gain or a capital loss. Either will have tax consequences.

If you sell the stock one year or less after purchase, the gain on the sale will be treated as a short-term capital gain and be subject to your ordinary income tax rates.

If it is sold more than one year after purchase, the gain will be treated as long-term and subject to lower long-term capital gains tax rates. Under current tax law, the maximum long-term capital gains tax rate is 20%, but most taxpayers will pay a lower rate.

This is also where taxes on ESPPs get complicated.

If your plan is non-qualified, the gain on sale will be calculated by the sale price of the stock, minus the full price at the time of purchase. This is because you will have already paid ordinary income tax on the discounted amount when you purchase the stock.

For example, Let’s say on the purchase date, the market value of the stock was $100, and you paid $85. Then, two years later, you sell the stock for $120. You’ll pay long-term capital gains on $20. (You already paid regular income tax on the $15 discount at the time of purchase.)

However, under a qualified plan, you’ll pay capital gains on the difference between what you actually paid for the stock (regardless of the market value at the time) and the sale price. This may result in higher capital gains on stock purchased through a qualified plan.

In this case, using the same example as above, you’d pay long-term capital gains on $35 (120-85).

Your employer is not required to withhold taxes to cover capital gains on the sale of stock purchased through an ESPP. The sale of the stock will be done on a personal level, requiring you to make tax estimates for capital gains at the time of sale.

Remember, it’s also possible to experience capital losses, just as it is with any other stock.

Should You Participate in an ESPP?

You should participate in an ESPP if your employer offers one. You’ll benefit immediately from the stock discount. An ESPP is like found money, similar to the employer match on employer-sponsored retirement plans.

With that said, you have to consider your personal financial situation. Participating will temporarily reduce your net income, so you should only participate in a plan up to the amount you can comfortably afford.

If you can’t afford it, consider a company like Benny, which will actually loan you money specifically to participate in your ESPP. Benny doesn’t charge interest, but they do charge 20% of your gains. So keep that in mind.

FAQs

When should I sell my ESPP shares?

You can sell stock purchased in an ESPP at any time. If you sell immediately after purchase, you’ll profit from the difference between the price you paid for the stock – at the discounted price – and its current market value.

You can also choose to hold onto the stock in the hope of selling for a higher price later if you believe the stock’s price will rise.

Can you make money on an ESPP?

You can make an immediate profit on the sale of stock acquired in an ESPP by selling it immediately to take advantage of the discount paid for the stock. You could potentially make even more if you hold the stock longer and the price rises.

Can you lose money on an ESPP?

In a word, yes. While this won’t happen if you sell your shares immediately – due to the discount – it’s always a possibility if you choose to hold onto the stock.

Bottom Line

Participating in your company’s ESPP plan can be a great way to earn some extra money. If your company allows for immediate sale of the stock, it’s a risk-free investment as you are buying the stock at a discount of the market value.

However, if you do hold the stock (either because you want to or because it’s required in the plan, you’ll be subject to the same market risk as you would with any other stock.

Other Posts You May Enjoy:

Apps Like Acorns

Acorns is a popular investing app with a round-up saving feature that automates the investing process. However, it's far from the only investing app available. Here are six more apps like Acorns. Learn more.

E*Trade Review (2024): Features, Pricing, Pros and Cons

E*Trade is an online brokerage offering free stock and ETF trades, along with managed investment portfolios. But with no fractional investing or ability to buy and sell crypto tokens, it might not be for everyone. Learn more in our E*Trade review.

ESOP vs. ESPP: What You Need to Know

Employee Stock Ownership Plans (ESOPs) and Employee Stock Purchase Plans (ESPPs) are valuable employee benefits that not all companies offer. Here's what you need to know about their similarities, differences, tax treatments, and whether or not you should sign up. Learn more.

E*TRADE Bonus Promotions: up to $1,000

Did you know E*TRADE will give you cash to open a new account? See the new account brokerage bonuses they pay out for large deposits before you open your account.

About Kevin Mercadante

Since 2009, Kevin Mercadante has been sharing his journey from a washed-up mortgage loan officer emerging from the Financial Meltdown as a contract/self-employed "slash worker" – accountant/blogger/freelance blog writer – on OutofYourRut.com. He offers career strategies, from dealing with under-employment to transitioning into self-employment, and provides "Alt-retirement strategies" for the vast majority who won’t retire to the beach as millionaires.

He also frequently discusses the big-picture trends that are putting the squeeze on the bottom 90%, offering workarounds and expense cutting tips to help readers carve out more money to save in their budgets – a.k.a., breaking the "savings barrier" and transitioning from debtor to saver.

Kevin has a B.S. in Accounting and Finance from Montclair State University.

Opinions expressed here are the author's alone, not those of any bank or financial institution. This content has not been reviewed, approved or otherwise endorsed by any of these entities.

As Seen In: