Getting the Most out of Your ESPP Part 2: Tax Considerations

In Part 1, we learned ESPP lingo, how the discount works, and contribution considerations. Now, let’s take a look at taxes.

Before diving in I’ll start with the counsel we typically give employees: because of the guaranteed benefit from buying your employer stock at a discount on the purchase date, it’s generally best to sell your stock as close to the purchase date as possible.

Clients often ask, “Is it worth holding onto my ESPP shares longer for the tax advantage?” Generally, no. This article gives that question a thorough treatment, showing you that the tax advantage of holding onto shares may not be much of an advantage after all.

Tricky Taxes

The good news is that tax only applies when you sell shares. You do not have to worry about tax when shares are acquired through ESPP. The less-good news is that taxes on ESPP shares can be a bit complicated. To simplify how ESPP taxation works, we’ll work our way through two examples with Erin from XYZ Inc.

Erin’s ESPP provides a 15% discount on XYZ stock, starts on the first of the year and purchase date is every 6 months. She’s a champ and contributes the maximum allowed, or $10,625 every 6 months.

XYZ stock trades at $100 at the offering date and $110 six months later at the purchase date. Erin gets a 15% discount off the lower offering date price of $100. The ESPP purchases 125 shares at the discounted price of $85 and deposits them in Erin’s account. In example 1, Erin sells right away. In example 2, she waits and sells after 18 months to get special tax treatment.

Example 1: Sell Right Away (Disqualifying Disposition)

Selling ESPP shares right away is called a disqualifying disposition. In a disqualifying disposition, any gains in the shares are taxed at ordinary income tax rates.

In this example, Erin immediately sells all 125 shares at $110/share and pockets $13,750. Her $10,625 investment has a gain of $3,125. That’s incredible. She gained 29.4% over the 6-month period when investors in the open market only gained 10%.

But Erin owes taxes on the $3,125 in gains from the account. The whole gain will be taxed as earned income. Assuming a marginal tax rate of 24%, Erin would owe $750.00 in Federal tax. Subtract that from her gain and she nets $2,375.00 after taxes. Add this to the $10,625 she put in, and she ends up with $13,000 to fund the next goal.

Selling shares right away allows Erin to:

1. Lock in the gain from the discount received when buying the stock
2. Reduce the risk of single-stock exposure through diversification
3. Direct those funds to invest for another goal, pay off debt, or whatever else she wants to do
   
   

However, one downside of selling shares right away is potentially paying a higher tax rate on the gains. But how much higher? Let’s find out.

Example 2: Sell After 1.5 Years (Qualifying Disposition)

For Erin to get special tax treatment from a “qualifying disposition”, she’ll need to be patient. To make a qualifying disposition, shares must be held at least 2 years from the offering date, and 1 year from the purchase date. For Erin’s case, since her offering date started 6 months before the purchase date, she needs to hold the shares for 1.5 years to meet the special holding period.

The advantage of a qualifying disposition is it allows any gains above the discount to be taxed at lower long-term capital gains rates. The key words are above the discount. That 15% discount is always taxed as earned income.

Erin will illustrate. For an apples-to-apples comparison, we assume she waits 1.5 years and sells XYZ stock when it is still trading at $110. Under this scenario, the discount of $15/share is taxed at her ordinary income rate of 24%, but the rest of the gain ($10 per share) gets a more favorable long-term capital gains tax treatment. It’s only taxed at a 15% rate.

Erin ends up owing $637.50 in Federal tax instead of the $750 she would have paid in a disqualifying disposition: $112.50 less. By selling right away she nets $13,000. By holding 18 months she nets $13,112.50. As you can see, the benefit of holding the stock isn’t massive.

Is Holding ESPP Stock for a Tax Advantage Worth it?

The question then becomes, should you sell right away to diversify or wait to meet the special holding requirement and pay a lower tax rate? Put another way, how much does it cost to diversify your single stock concentration and is it worth it?

In Erin’s example, the cost of reducing her single stock exposure was $112.50. This can also be viewed in terms of the risk of not diversifying. How much would the company share price need to fall in order to lose the tax benefit of waiting to sell? Erin has 125 shares. If the stock price drops $1, or less than 1% during the 18-month window, she loses $125, completely washing out the tax benefit.¹

You do come out ahead in your ESPP if the stock gains a lot from the day you purchase stock to the day you sell it. But there is no guarantee and a lot can change in 18 months. The rare thing about ESPP compared to other stock positions is that you don’t need a crystal ball to come out ahead. Because of the discount, you start with an advantage. All you need is the discipline to sell right away to lock in your gains.

Using ESPP Proceeds to Fund Your Financial Goals

Selling and paying taxes on the gain allows you to use that money to fund another goal, like paying off debt, building your emergency fund, investing for a home down payment, or even funding your next round of ESPP.

When you stick with your Employee Stock Purchase Plan, every 6 months you’ll have a big chunk of stock to decide what to do with, presenting a great opportunity to advance your financial plan. In the final article of this series I’ll cover a few ways to leverage your semi-annual ESPP windfall to further your financial goals.

[1] To simplify this article, we just included one example of tax rates. A qualifying disposition can become a greater or lesser benefit if your tax rate is higher or lower than the example given. The table below shows the difference between tax rates and how much the stock needs to lose from your original purchase price in order to lose the advantage from holding the stock until you can make a qualifying disposition.

Note: If you are subject to the net investment income tax (NIIT), add 3.8% to your capital gains tax rate, further reducing the tax advantage. You are subject to the NIIT if your Modified Adjusted Gross Income is above $200,000 for single and $250,000 for married filing jointly tax filers.