An employee stock purchase plan lets you buy stocks at the company you work for at a discounted price

An employee stock purchase plan lets you buy stocks at the company you work for at a discounted price

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An employee stock purchase plan can help you build equity.

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  • An employee stock purchase plan (ESPP) lets employees at publicly traded companies buy company stock at a discounted price.
  • Employees can enroll in an ESPP by making contributions that are deducted automatically from their paycheck to save up until the purchase date.
  • How ESPPs are taxed depends on whether it’s qualified or non-qualified — and whether you decide to sell your shares later.

Landing a new job at a publicly traded company can be exciting. In addition to a 401(k) match and health insurance, publicly traded companies may also offer an employee stock purchase plan (ESPP).

What is an employee stock purchase plan?

An ESPP allows employees to buy stock for the company they work for at a discounted price, typically up to 15% off. Some companies offer ESPP as soon as you start, while others wait until you’ve been there for at least a year.

If you truly believe in the company’s mission and that its value will grow, it might be beneficial to hold equity — another word for shares or ownership — in the company that you work for.

Your employer’s plan might have a limit on how much you can purchase, and they might also have a cap on what percentage of your take-home pay you can actually contribute, says Charly Kevers, chief financial officer at Carta, an equity and ownership management company. “The IRS currently doesn’t allow the employee to purchase more than $25,000 worth of stock per calendar year through ESPP,” he adds.

How does an employee stock purchase plan work?

An ESPP allows you to buy stock in the company you work for through automatic post-tax paycheck deductions. Up to 15% of your paycheck after taxes and retirement deductions gets automatically deposited into an account held by your employer brokerage during the offering period, the period of time between starting ESPP and the purchase date. At the end of the offering period, all the money you saved will be used to buy the stock at the agreed-upon price.

“Similar to a 401(k), you choose how much you want to contribute. Your company takes that amount out of your paycheck post-tax and holds onto it. Then, on designated purchase dates, your employer uses that money to purchase and issue shares back to you,” says Kevers.

The IRS limits you to a maximum contribution of $25,000 for 2022, although your employer may cap your contributions further or even as a percentage of your income.

Example of how an ESPP works

For example, let’s say you start working at Company ABC Inc. and it offers its employees an ESPP, and its shares are currently trading at $100. If you choose to participate, the ESPP might allow you to buy 100 shares at $85, which is 15% lower than the current price of $100. No matter how much the price of the stock increases at the time of your purchase date, you’ll still be able to secure 100 shares at the price of $85.

If you plan on buying 100 shares of Company ABC Inc.’s stock at $85 and your purchase date is in two years, you might ask your employer to hold $177.08 per month from your paychecks to cover the $8,500 you need to buy those 100 shares.

Example ESPP Calculations for Company ABC Inc.

Current stock purchase price

$100/share

Stock purchase price with ESPP discount

$85/share

ESPP offering period

Two years

Total purchase over two years

$85/share x 100 shares = $8,500

Automatic paycheck deductions for two years

$8,500 / 24 = $354.16 / 2 = $177.08 per paycheck

How are ESPP stocks taxed?

How your ESPP is taxed depends on what type of plan you have. “There are two types of ESPPs, which affect tax treatment,” Kevers says. He recommends checking in with your employer to see if they offer qualified section 423 ESPPs or non-qualified ESPPs

Here are the key differences:

Qualified plans

Non-qualified plans

Meets the criteria outlined in Section 423 of the Internal Revenue Code

Does not meet the criteria of Section 423 of the Internal Revenue Code

Must be approved by company shareholders within 12 months of the date the plan is implemented

Shareholder approval is not required

Contributions made with after-tax dollars

Contributions made with after-tax dollars

Restrictions on the maximum price discount allowed

No prices restrictions

Favorable tax treatment given if employees hold shares for at least two years from the grant date and one year from the purchase date

When shares are purchased, the excess of the fair market value at the time of purchase is taxed as ordinary income

Plan design less flexible

Plan design is flexible

You might pay less in taxes with a qualified ESPP, but there are more restrictions

Kevers explains, “If you have qualified ESPPs and you hold your shares at least one year after your purchase date and two years after your offering date, you’ll pay ordinary income tax on the difference in price between the discounted price and the offer date price. The difference between the offer date price and the final sale price is treated as long-term capital gain or loss.”

According to Fidelity, US tax law states that employees cannot be taxed on profits because of the discount. Going back to our Company ABC Inc. example, if the price of the company’s stock is $125 by the time of your purchase date, you’re looking at a total profit of $4,000. However, only $2,500 of your total profit can actually be taxed.

Example calculations for stock in Company ABC Inc.

Current stock purchase price

$100/share = $10,000 value

Stock purchase price with ESPP discount

$85/share

ESPP offering period

Two years

Total purchase over two years

$85/share x 100 shares = $8,500

Price of stock after the two-year offering period

$125/share = $12,500

Total profit after two years

$12,500 – $8,500 = $4,000

Profit from stock appreciation (taxable)

$12,500 – ($100/share x $100 shares = $10,000) = $2,500

Profit from ESPP discount (non-taxable under a qualified ESPP)

$4,000 total profit – $2,500 = $1,500

If the stock was valued at $100 during your offering date and you sold your shares at $125, you’ll be taxed only on the difference between those two prices. However, a holding period will be required to reap those tax benefits.

If you hold onto that stock for one year after your purchase date and two years after your offering date, says Kevers, you’ll have to pay long-term capital gains taxes on the $2,500 profit that you made. Depending on your income, long-term capital tax gains are usually lower than the ordinary income tax rate.

“If you don’t hold qualified shares for at least one year, you pay ordinary income tax on the difference. The spread between the sale price and purchase date fair market value is treated as short-term capital gains,” says Kevers.

Non-qualified ESPPs are less restrictive, but you pay more in taxes

On the other hand, non-qualified ESPPs aren’t as complicated or restrictive as qualified ESPPs, but you may end up paying more in taxes.

“If you have non-qualified ESPPs, you pay taxes on the difference between the value of the shares at purchase and the price you paid when you purchase the shares,” says Kevers.

Using the Company ABC Inc. example again, you’ll have to pay taxes on the total profit of $4,000, though the main benefit over a qualified section 423 ESPP is that you can sell the stocks at any time.

Current stock purchase price

$100/share = $10,000 value

Stock purchase price with ESPP discount

$85/share

ESPP offering period

Two years

Total purchase over two years

$85/share x 100 shares = $8,500

Price of stock after the two-year offering period

$125/share = $12,500

Total profit after two years (taxable under a non-qualified ESPP)

$12,500 – $8,500 = $4,000

ESPPs vs 401(k)s

Generally, an ESPP is not a replacement for a traditional retirement plan, like a 401(k) or Roth IRA. An ESPP is similar to buying individual shares of stock in the market to sell at any time, while a 401(k) or Roth IRA is specifically for retirement purposes to be withdrawn later in life.

“Employees might consider consulting a financial advisor for their particular situations. A 401(k) or IRA tends to be invested in a basket of stocks — it’s more diversified — whereas an ESPP only allows employees to purchase stock in their employer,” says Kevers.

ESPP

401(k)

Contributions made via payroll deductions

Contributions made via payroll deductions

Contributions made after taxes

Contributions made pre-tax

5% to 15% discount on stocks purchased

No discount on stocks

Only buying stock in one company

Generally, a diversified basket of stocks

Taxation is based on whether the plan is qualified or non-qualified

Contributions are pre-tax and withdrawals during retirement are taxed at an ordinary income tax rate

Contribution limit of $25,000 a year

Contribution limit of $20,500 a year, and an additional $6,500 in catch-up contributions if over 50

Offers a lookback period where the plan can use a previous closing price of the stock

No lookback period offered

Plan designed to offer equity and a form of compensation to employees

Plan designed to help employees save for retirement

Ability to sell stocks at any time

Penalties for withdrawing from your 401(k) before the age of 59 ½ 

Read the original article on Business Insider

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