An employee stock purchase program, or ESPP, allows employees of a publicly traded company to buy company shares through their paycheck. Usually employees can contribute 1-10% of their pretax paycheck toward the ESPP in return for discounted shares, which they receive at predefined intervals from the company. This stock purchase discount is usually around 15%, but while most people see the ESPP as a way to earn 15% on their investment the true return is in fact at least 17.65%!
Before I explain, let’s make sure we’re all on the same page about stock purchase programs. While every employer’s program might be slightly different, below is a typical structure of an ESPP:
- You can contribute from 1-10% of your pretax salary, but your contribution is taken after tax.
- Your employer will hold your contribution for a given period of time, after which you will receive an amount of company shares proportional to your contribution. This period is usually called the purchase period, and it is often 3 or 6 months long.
- You can often sell the shares the same day that you get them, but some employers might subject you to a blackout period for several weeks after you receive your shares.
- Employers usually give you a discount on the lowest closing price of the stock on either the first or the last day of the purchase period, whichever is lower.
Now, let’s take a look at the numbers. Let’ say you are earning $80,000 per year and you elected to contribute 10% of your salary toward your ESPP. You’re paid every other week, so your pretax paycheck is about $3,077. This mean that you’ll be contributing $308 to your ESPP, which after tax is going to reduce your take-home pay by about 16%, not 10% – just a heads up on that because, remember, money for your stock purchase program is taken after tax. If you receive stock quarterly, let’s say that the closing price on January 1st was $100.00 and on March 31st it was $100.01. In that case, you’ll get a 15% discount on the $100.00 price, which puts your purchase price at $85.00.
Over the entire quarter you received six paychecks so a total of 6 * $308 = $1,848 went to the purchase. Therefore, you received $1,848 / $85.00 = 21.74 shares. If you sell those share immediately at the current price of $100.01, which is essentially the same price as the start of the quarter, you will get back 21.74 * $100.01 = $2,174, which is a gain of 17.64%, not the same as the 15% discount you got on the shares!
It gets even better. Let’s say the stock grows by 10% over the next few months to reach a price of $110.00. Then you sell. You will see a 29% return on your investment just from that 10% growth thanks to your original 15% discount. That’s almost 3x the return of someone who bought the stock on the market on Jan 1st, the same day your ESPP was priced! As you can see, an ESPP is not something to pass up if you have the cash to spare and if you think your company stock is 1) going to increase in value or 2) not lose any value.
We know we have a great return when we use our ESPP. But let’s see how much taxes will eat into our investment. If you sell your shares the day you receive them – or any time before 1 year following the issue date – you’ll be taxed short term capital gains tax at your marginal income tax rate, which with your $80k salary will put you in the 25% tax bracket. There are four scenarios to consider: you sell the same day, you sell after a couple of months, and you sell a year later at two different prices.
1) If you sold the same day: short term capital gains tax. You will have gained $326, which taxed at 25% nets you an additional $245 from an investment of $1,848. This leaves you with a final return of 13.2% after tax. If you didn’t buy through the ESPP you would’ve seen a 0% return before and after taxes.
2) If you sell after a couple of months and the price increases by 10% since the issue date: short term capital gains tax. You will gain $543, taxed at 25% nets you an additional $407. This leaves you with a final return of 22% after tax. If you didn’t buy through the ESPP you would see a 7.5% return after taxes.
3) If you sell over a year after the issue date and the price doesn’t change: ordinary (long term) capital gains tax at 20%. You will gain $261 after tax from an investment of 1,848. This leaves you with a final return of 14.1% after tax (slightly greater than the 13.2% gain and $245 you would’ve seen if you sold the same day, in #1). If you didn’t buy through the ESPP you would’ve seen a 0% return before and after taxes once the year is up.
4) If you sell over a year after the issue date and the price increases by 10%: ordinary (long term) capital gains tax at 20%. You will gain $435 after tax from an investment of 1,848. This leaves you with a final return of 23.5% after tax. If you didn’t buy through the ESPP you would see an 8% return after taxes. This is of course the best scenario, and you can see how much of an advantage you have on your return if you use your employee stock purchase program.
So what should you do? It is always beneficial to buy into your ESPP if you feel the price of the stock is relatively stable or has growth potential. If you anticipate to price to stay relatively flat or are worried about it’s decline, sell the shares the same day – don’t wait to switch from short term capital gains to long term capital gains tax. The increase in ROI from 13.2% to 14.1% isn’t worth the risk of hanging on to the stock for a year if thing’s aren’t looking up for the company. If you’re going to do this just make sure that there is enough trading volume on your company’s stock to unload the shares immediately, and that the bid/ask spread isn’t to great. If the bid/ask spread is high and there isn’t much volume then you might not be able to sell your shares at the desired price. However, if you feel the company will do well then hang on to the shares for at least one year before selling and you will have a big advantage in your returns.