ESPP’s are often the source of a lot of confusion so i thought it would be a good topic to post on. Most people don’t realize they are giving up FREE money by not participating in these plans.
What is an Employee Stock Purchase Plan or ESPP?
It is a stock purchase program that allows employees to purchase stock at a discount, usually 10 or 15%
Most large public companies offer these programs. Check with your HR department to see if yours does. If the program meets a few simple criteria they can be a great way to get FREE money. We all like FREE money 🙂
So how does it work?
Employees contribute after tax dollars, up to a pre-defined maximum, to an escrow account. At the end of the plan period, either quarterly or semi-annually, the company uses the escrow money to purchase the stock at the closing price minus the discount.
What about the free money part?
You need to read the fine print and see if there is any kind of holding period. If there is NO holding period you should contribute to the MAXIMUM the plan allows. As soon as you get the discounted shares, turn around and sell them the next day for an automatic 10 or 15% return on your investment!
The Home Depot Example
Here is how it works at Home Depot, we will use a sample salary of $50k for easy round numbers.
- Semi-Annual Plan
- You can contribute up to 20% of your pre-tax salary
($5k per plan period / $384 per pay check)
- 15% discount on the closing price of the last day of the plan period
- No holding period
This works out to a 3% bonus per year or $1,500. Not bad for doing nothing but a little planning. The tricky part with this is that the 20% will take about of a third of your paycheck when you take taxes into account.
|Bi-weekly Gross Pay
On the plus side this is a GREAT way to save money for big purchases and to live on less than you make.
What about the taxes? Shouldn’t you keep the stock for at least a year to pay less in taxes?
Here is how the taxes work. If you sell the stock right away, the IRS considers it as ordinary income. If you hold the stock for at least a year you will pay capital gains which is 15%.Â So yes, you would pay taxes if you held the stock but you always have to evaluate risk.Â There is an added risk to doing that and for me I just don’t think that risk is worth it. For example, we received the most recent allocation of ESPP shares in July at $38. By the time the shares were in my account (~10 days) the stock was at $40 and I sold them immediately. The stock is at $34 today!
I am an avid believer that you should not invest in the individual stock of the company you work for.Â You already have your income tied directly to the success of the company, you don’t want your investments to also be impacted if the company takes a turn for the worse.