Having access to a rich menu of benefits at work can be incredibly valuable. However, if you don't know what all the benefits mean or how they work, it can be hard know which ones you really need.
An ESPP could be easy to overlook, particularly if it's a benefit you've never encountered before. If your employer offers an ESPP, it may be worth your time to dig into the plan's details and consider signing up. Here are some basics on ESPPs, to help as you're getting started exploring your plan.
What is an ESPP?
ESPP stands for employee stock purchase plan. It's a plan that lets employees buy their company's stock—usually at a discount—on a set schedule over time.
If your employer offers an ESPP and you enroll, you choose an amount to be deducted regularly from your paycheck. Those deductions accumulate over time, such as 3 to 6 months, and are periodically used to buy company stock on your behalf. Once the stock has been purchased, it's yours to hold, manage, or sell.
What are the benefits of an ESPP?
The potential benefits of participating in an ESPP may include:
- A convenient way to save and invest. Because ESPP contributions come directly out of your paycheck, participating can help remove the temptation to spend that money—automating your savings plan and making it painless.
- Buying at a discount. Many ESPPs allow employees to purchase their company stock at a discount—most often 15%. Some plans also include a feature called a "lookback," which can increase the effective discount when the stock price is appreciating.
- Participating in your company's potential success. Holding your company's stock gives you an ownership stake in your employer. If your company does well, the value of your stock may increase.
How does an ESPP work?
Here is a look at the lifecycle of a typical ESPP (though keep in mind that plans can vary):
- Become eligible to participate and enroll in your plan. Open your account if you don't already have one. During the enrollment window, you can choose how much you want to come out of your paycheck over the coming purchase period to buy company stock.
- Your contributions accumulate during the purchase period. Your company collects contributions from your paycheck, so you don't have to do anything during this step.
- Stock is purchased on your behalf. At the end of the purchase period, your contributions are used to buy company stock. If the ESPP offers a discount, the stock will be bought at a discount to its market value.
- Adjust your contributions for the next purchase period, if desired. When the next enrollment window opens, you can increase or decrease your level of contributions.
After they're purchased, shares will be deposited into your account, and you can log in to see the number you received. Most plans allow you to sell at any time. However, some may require you to hold your shares for a minimum period of time after purchase (such as 3, 6, or 12 months), or may restrict the sale of shares during company-imposed trading windows.
Be sure to check your plan rules for specific details of how your plan works.
How is an ESPP taxed?
Tax treatment of your ESPP depends on whether your plan is qualified or nonqualified. Check your plan documents to understand the type of plan your company offers.
For US taxpayers in a qualified plan, you're not taxed when shares are purchased, only when you sell. Depending on how long you held the shares, a portion of your gain may be taxed as capital gains and/or as ordinary income. In a nonqualified plan, you owe tax at the time of purchase, with ordinary income tax owed on the difference between the fair market value of the stock and the amount you paid. (Employers that offer nonqualified plans will typically withhold the taxes due at purchase on behalf of participants.) Additional tax may be due when you sell.
Consider working with a tax professional to understand the tax implications of participating in your ESPP.
Important features of an ESPP
As you're reading your plan documents, be sure to look for details on the following:
- Discount rate. Most, but not all, ESPPs let employees buy shares at a discount. The most common discount is 15%, but some plans offer 5% or 10%.
- Lookback provision. In plans with a lookback provision, shares will be purchased using the lower of 2 prices: either the stock price at the beginning of the purchase period, or the price on the purchase date. Any discount will be applied to the lower of those two prices. For example, if the stock has risen in price during the purchase period, your purchase price is calculated by applying the discount to the lower, beginning-of-period price—letting you acquire it at a price that's already lower than its current market value.
- Number of purchase periods per year. The purchase period is the time when payroll deductions accumulate, with shares purchased at the end of the period. For example, if your plan has two purchase periods per year, then there will be two times per year when shares are deposited into your account.
- What happens if you need your money back before the purchase date. You can generally withdraw from the plan at any time before purchase, in which case you get back the cash that had been deducted from your paychecks during that purchase period.*
Know your plan
Details of ESPPs can vary widely among plans. It's important to understand the features of your company's plan when you're deciding whether to enroll and how much to contribute.