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The Ultimate Guide To Employee Stock Purchase Plan (ESPP)

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Why You Should Enroll in an employee stock purchase plan

Why do you care about Employee Stock Purchase Plans (ESPP)? If you enroll in the employee stock purchase plan offered by your company you can make more money! ESPP is a benefit offered by some publicly traded companies to their employees. ESPP is the ability to purchase company stock through payroll deductions at a discounted rate.

The effort required is minimal and requires enrolling in ESPP and selling the shares to realize gains (or losses). You have a guaranteed return if you sell the day you receive the shares. If you decide to hold the shares for longer, and the shares increase in value, it will help you accumulate wealth. Companies can offer a maximum discount of 15% on company shares. With current savings accounts interest rates at best at 1.5% APY, and average stock returns at 5-7% a year, but not guaranteed, this is a great deal.

If you’re considering enrolling in ESPP here are the terms you should know, the benefits of ESPP and approximately how much extra income you may be able to make.

Employee Stock Purchase Plan Terms To Know

  • ESPP Enrollment Period: defined set of dates where you can sign up to participate and select the % election amount. If you miss this enrollment period you will have to wait for the next enrollment period (either 6 months or 1 year later depending on the terms)
  • ESPP Purchase Period: Timeframe in which company shares are purchased on your behalf through payroll deductions. There may be two purchase periods a year, one beginning Jan 1st  and ending on June 30th, with the second starting July 1st and ending Dec 31st. You do not have access to the money you’ve contributed during this time.
  • ESPP Purchase Price: Usually, the purchase price is the price of the stock on the last day of the offering period, with the discounted rate applied. In the example above, it would be the ending stock price on June 30th and December 31st.
  • ESPP Holding Period: You can sell your ESPP shares at any time, even the same day you get the shares. However, in order for the sale to be taxed as a capital gain it must be considered a qualifying disposition.
  • ESPP Qualifying Disposition: A qualifying disposition refers to a sale, transfer or exchange of stock that qualifies for favorable tax treatment. ESPP falls within this definition. To be a qualifying disposition, the employee must sell their position at least one year after exercising the stock or two years after the beginning of the ESPP offering period. As long as you hold your ESPP shares for this time period you are taxed at a capital gains rate. If you sell prior to this period, it is considered a disqualifying disposition. A disqualifying disposition is taxed at the income tax rate.

Employee Stock Purchase Plan IRS Limits

The IRS imposes a limit of a maximum market value of $25,000 per year. However, companies can decide to impose lower limits. That means if your company grants you shares at a 15% discount, the max you can contribute is $21,250. The purchase discount also tops out at 15%, but your company could choose to offer less than that as well. Every plan can vary so be sure to look into the details around what plan your company offers.

Employee Stock Purchase Plan Tax Rules

The stock discount price (up to 15%) is considered additional compensation and taxed as ordinary income. If you sell that day, it is disqualifying and will be taxed as a short term gain / ordinary income. If you hold shares for at least 2 years from the first day of the offering period and at least one year from the purchase date, the additional income is considered a “qualifying dispositioned” and will be taxed as a long-term capital gain (15% tax rate for most taxpayers).

Additional Income Earned with Employee Stock Purchase Plan

The tables below offer a guide to how much additional income you can make after taxes if you sell that day per year. If you decide to hold onto the stock for the time period outlined below, your taxes will be 15% (for most taxpayers) for the discounted amount + any gains you made while holding the stock. Remember, it is always possible for the stock to lose value.

Additional income you can make from participating in an employee stock purchase plan by tax bracket when you sell the same day you get the ESPP shares for single tax filers
*1% assumes average (mean) income of tax bracket
**Assumes all income would have been taxed at the rate of that bracket
Additional income you can make from participating in an employee stock purchase plan by tax bracket when you sell the same day you get the ESPP shares for married filing jointly tax filers
*1% assumes average (mean) income of tax bracket
**Assumes all income would have been taxed at the rate of that bracket

It’s hardest to maximize the program when you make less money, but that’s when this is actually the most valuable! When your tax rate is only 22%, you could make almost $2,500 after taxes. If you’re in the highest tax bracket you make only $2,000 after taxes. The first purchase period is always the toughest. You’re used to getting that money in your paychecks every pay period. After the first purchase period is done, if you sell all your shares immediately you have everything you’ve invested from the past 6 months plus the additional income you made as soon as the sale settles!

If you work for a public company, check out your internal benefits page and see if this is one of the benefits your company offers!

See Also: Company 401(k) Match and Why You Should Max Out Your 401(k)

Max Out Your 401(k) Contributions in 2021

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401k contribution limits 2020 - picture of computer with 401k graphs and contribution amounts

A 401(k) plan is a retirement savings plan sponsored by employers that allows employees to contribute to their retirement savings pre-tax. If you can, you should always max out your 401(k) plan. The 401(k) contribution limit for 2021 is $19,500, unchanged from 2020. 401(k) plans have many benefits including tax benefits, employee company match and accelerating funding your retirement. Maxing out your 401(k) every year, or contributing up to the contribution limit, enables you to take full advantage of all of these benefits. Even if you’re not sure how you’ll be able to afford contributing $19,500 to your 401(k) this year there are steps you can take throughout the year to get closer to this goal.

When to Plan Your 401(k) Contributions

The beginning of the year is the best time to plan 401(k) contributions for the year. This way, you can spread out your contributions evenly throughout the year. The amount taken out per paycheck will be consistent that way. However, if you do hit the maximum amount early you’ll get a nice surprise of extra money in your take home pay at the end of the year as well as extra money taken out for taxes. If you wait until later in the year to plan your 401(k) contributions it may not be financially feasible. You’ll have to contribute more per paycheck to hit the max, or you may not earn enough the rest of the year to hit $19,500 in contributions. Don’t forget to check your 401(k) in the summer to ensure your contributions are on track to max out your 401(k) this year.

Make Sure To Always Get the Company 401(k) Match

Does your company automatically enroll you into their 401(k) plan? If not, make sure you sign up! Most companies that offer a 401(k) plan also offer a company match. At minimum, you should always contribute enough to your 401(k) to get the full company match. This is free money! The 401(k) company match is one of the top benefits of a 401(k) plan.

It’s hard when you first graduate college and starting from scratch- all the fees with the first apartment, first furniture buys, starting those student loan payments, etc. You may also have to save for bigger purchases like a house down payment and a car. It’s easy to feel like there is just no money to save for retirement.

Instead, look at how you are spending your money and find a way to contribute enough so you get the full company 401(k) match. After that, there are strategies to increase your contributions without feeling like you now have less money to spend over time.

Increase Your 401(k) Contributions During Raises and Promotions

Every time you get a raise or promotion you could afford to increase your 401(k) contribution more. Most companies have an annual raise cycle and if you’ve set your 401(k) contributions to a percentage of your salary your contributions will automatically increase when you get your raise. This time of year is also a great time to increase the percentage you contribute. You have already learned to live on your previous salary, do you desperately need that increase to buy more stuff? If you get a $5,000 raise you can increase your contributions by $1,000 a year and still have $4,000 of your raise. You won’t miss that last $1,000 while you’re adjusting to the extra $4,000 you are now earning every year. Using the table below, you can take the annual amount and divide it by the amount of paychecks per year to get the amount withheld out of each paycheck.

Increase Your 401(k) Contributions When You Finish Paying A Big Expense

Whether it’s putting down your first down payment, or paying off your last student loan, you now have one less expense. Reallocate what you would have spend on that expense to your 401(k) contributions. You won’t miss having the “extra” money because you didn’t have it before.

Enroll In The 401(k) Annual Increase Program

Some plans offer an annual increase program where you can establish annual increases. It depends on the plan, but at least some Fidelity plans allow 401(k) contributions to increase 1% or more each year automatically. You have the ability to align it to pay increases as well and then just set it and forget it. Automating 401(k) contribution increases is the easiest way to increase your contributions. If you end up needing more cash every paycheck you can always go online to your 401(k) plan provider website and reduce your contributions.

401(k) Tax Benefits

You know contributions to a 401(k) plan is pre-tax, but have you ever done the math as to how much you’re saving in taxes by contributing to your 401(k)? You may think you can’t contribute anymore but don’t forget you’ll also save money on taxes.

If you contribute $19,500 to your 401(k) in 2020 here are the tax savings you can expect with the current federal tax brackets. If you are single and making $62,825 a year (mean salary in the 22% tax bracket) you’ll avoid $4,290 in taxes. When you’re making $62,825 a year as a single filer for every 1% additional of your salary you contribute to your 401(k) you’ll avoid $138 in taxes.

401k contribution limits in 2020 - How much in taxes you avoid by tax bracket as a single filer by contributing the maximum amount to 401k in 2020
2020 Tax Savings for Increased 401(k) Contributions for Single Filers
*Assumes average income of tax bracket
**Assumes all income would have been taxed at the rate of that bracket
401k contribution limits in 2020 - How much in taxes you avoid by tax bracket as a married filing jointly filer by contributing the maximum amount to 401k in 2020
2020 Tax Savings for Increased 401(k) Contributions for Married Filing Jointly Filers
*Assumes average income of tax bracket
**Assumes all income would have been taxed at the rate of that bracket

401k Benefits Include Compound Interest

Last, but not least, if you need a little more motivation to max out your 401(k) don’t forget about compound interest.  The hardest time to contribute to your 401(k) is when you’re young, as you have a lot of big expenses on the horizon and likely the lowest income you’ll ever have. But, thanks to compounding, the more you save early on the less you’ll need to save later. Take this example from the team at J.P. Morgan Asset Management in their  2014 “Guide to Retirement.” Here, they share how much money you can make from investing $5,000 a year over time depending on when you start.

Compounding interest graph showing how much you will make from investing $50,000 over time.
Example of Compounding from J.P. Morgan Asset Management 2014 Guide to Retirement

Don’t forget, a 401(k) is one of several options to save for retirement. After you’ve hit your employee match in your 401(k) plan, start contributing to your Roth IRA account before maxing out your 401(k) in order to fully optimize the tax benefits in your retirement savings strategy.