Employee stock purchase plans (ESPP) can be a generous workplace benefit. However, workers often shy away from using these plans because they don’t quite understand how an ESPP works. Tax-qualified ESPPs, also called Section 423 plans, can be a great way to diversify as you save for retirement, a car, or a down payment on a home. If you have an ESPP, it’s important to understand how it works so you can see why it might be worth participating.
How an employee stock purchase plan works
Section 423 employee stock purchase plans allows you to buy shares of your company’s stock, typically at a discount. Most often, participants elect to fund their ESPP account through regular payroll deductions, up to $25,000 per year. At certain points, your employer will use your contributions to buy shares of the company’s stock. The central motivator for employees to participate is the opportunity to purchase shares below market price, typically at a reduction of 5% to 15%.
In addition to the upside of buying under current market value, ESPPs also give you greater access to your money compared to other retirement plans. If a need arose, portions of your holdings could be liquidated before retirement without incurring the 10% penalty on early 401(k) withdrawals.
Keep in mind that an employee stock purchase plan is not the same as stock options or equity awards like RSUs. An ESPP may be offered in addition to other equity based compensation so it is important to understand how stock options work.
When you first buy shares under an ESPP, you won’t owe any taxes. Taxes will be due the tax year of the sale, but whether all (or a portion) of the gains will be taxed at ordinary income rates, long-term or short-term capital gains will depend.
Without getting into the specifics, sales are classified as either a qualifying or disqualifying disposition based on how much time has passed since the offering date (when your contributions began), and when the shares were purchased and sold. Normally the most favorable tax treatment comes with a qualifying disposition, which means the sale occurred over two years after the offering date and at least one year after purchase.
All plans aren’t created equal
As you consider whether your firm’s ESPP is right for you, carefully review the specifics of the plan with your financial advisor. There can be a lot of variability between plans which will benefit participants differently depending on their personal situation and financial goals.
With the right plan, an ESPP can be a valuable part of your compensation package and add diversification to your investment portfolio. If your company offers one, it is certainly worth looking into.