Some companies allow their employees to buy company stock through something known as an Employee Stock Purchase Plan, or ESPP. Employee stock purchase plans can generate gains for employees when sold, as they are purchased at a discount. If you have an opportunity to join an ESPP, it’s one way to increase your overall compensation from your job.
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.
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What Is an Employee Stock Purchase Plan (ESPP)?
An ESPP is a benefit program some employers offer to their employees that enables them to purchase stock in the company. The employer must be a publicly traded company, and the stock is usually made available at a discounted price to its market value.
Employees contribute to the plan via payroll deductions, the same way they would contribute to a 401(k) plan. The payroll deductions accumulate and are used for the purchase of company stock on the purchase date.
Employees are permitted to contribute up to 10% of their gross pay to an ESPP. Purchase terms are typically set every three, six, or 12 months each year the plan is in effect.
Under IRS rules, ESPPs can allow for the purchase of company stock at a discount of up to 15% of its fair market value. Values are determined by the financial markets on the date of purchase.
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?
To be eligible to participate in an ESPP, the employee needs to be employed by the company for a certain period of time. This timeframe varies by employer and could be three months, six months, or even one year. Otherwise, participation in the plan is open to all employees.
Participating employees have the option to purchase the stock at a discount, which can be up to 15%. The intervals employees can purchase a given issue of stock are referred to as an offering. The employer might choose to make offerings quarterly, semiannually, or annually.
Plans are set up that allow employees to contribute up to 10% of their pretax pay to an ESPP (they can choose to contribute less). However, under IRS regulations, the maximum dollar amount of plan contributions is limited to $25,000. 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.
The accumulation of funds in the plan allows employees to build a cash balance with which to purchase company stock when it is offered within the plan. Employees are not required to purchase stock when offered and can retain funds in the plan for purchases of future offerings.
Cash paid into the plan can also be withdrawn at any time upon written notice to the employer.
The price at which the stock is made available during an offering can be set at either the date the offering is made, the date of purchase, or the lower of the two. This is determined by the employer.
Once an offering is made, employees will be given a specific timeframe to purchase the stock. This time frame is referred to as the offering period.
Qualified vs. Non-qualified ESPPs
There are two general classifications of ESPPs, qualified and non-qualified.
A qualified ESPP requires the approval of company shareholders. If the plan is qualified, 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 not tax-deductible. If your company offers an ESPP, you’ll need to consider this when determining what percentage of your income will go to a plan.
If the plan is non-qualified, you will be required to pay tax on the difference between the fair market value of the stock and the actual price you paid for it in the year you purchased the stock. In other words, you will have to pay tax on the discounted amount.
If the market price of a stock is $100 at the time of purchase, and the employee buys it for $85 (15% discount) – the dollar amount of the discount will become immediately taxable. If you purchase ten shares, the taxable gain will be $150 (the $15 per share discount X 10 shares purchased).
Under a qualified ESPP, the discount must be recognized as taxable income in the year when the stock has been sold, not 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 of the stock purchase. 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, less the full price at the time of purchase. This is because you will have already paid ordinary income tax on the amount of the discount at the time you purchase the stock.
However, under a qualified plan, your basis in the stock will be the discounted price you paid for it. This may result in higher capital gains on stock purchased through a qualified plan.
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.
Tax Treatment of Capital Losses
If you experience a capital loss on the sale of stock purchased through an ESPP, you can generally write off at least some of the loss. The IRS permits taxpayers to deduct the amount of capital losses incurred in a calendar year from the amount of capital gains accumulated during the same year.
You can deduct up to $3,000 as a loss for the year, with the option to carry forward losses to future years. Any amount of loss not deducted in the year incurred can be carried forward to future years. It can then be deducted against future capital gains. If there are no gains in subsequent years, the loss can continue to be deducted (up to $3,000 per year) until the loss is fully deducted.
FAQs
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.
As discussed above, 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.
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: 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. Since contributions to an ESPP are made with after-tax dollars, it will reduce your net income, so you should only participate in a plan up to the amount you can comfortably afford.
The post What Is an ESPP and Should I Participate in One? appeared first on Best Wallet Hacks.
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