Getting the Most Out of Your ESPP: Part 1

An ESPP (short for Employer Stock Purchase Plan) is a super valuable benefit offered by some publicly traded companies. The plan allows employees to purchase their company stock, often at a guaranteed minimum discount. The discount varies from company to company, but it typically ranges from 5% to 15% of the fair market value.¹

Learning the Lingo

In order to fully understand the ESPP, here's are some key terms from the plans to review:

Fair Market Value – The price of the company stock in the open market. Your discount is taken from this price on the purchase date.

Enrollment period - The period when you can enroll in your ESPP, deciding how much per paycheck to set aside to buy discounted stock. Typically, you have two one-month enrollment periods per year, immediately before a new purchase period starts.

Offering period: The length of time the ESPP runs. Your discount is sometimes offered based on the lowest price during the offering period.

Offering date: The date when a new cycle of the offering period starts.

Purchase period: The length of time your money accumulates before purchasing shares. Typically purchase periods last 6 months.

Purchase date: The day when company stock is purchased at a discount from Fair Market Value. For example, stock for the December 1st to May 31st purchase period might be bought on June 15th .

Savings Specifics

So what makes an ESPP so unique? Most companies provide a lookback provision. When you buy shares, the ESPP “looks back” at the previous offering period to take a discount from the lowest price during the period.

A lookback really boosts the benefit of an ESPP by 1) guaranteeing the discount regardless of how the stock price moves during the purchase period, and 2) potentially boosting the discount returns and magnifying your gains.

The best way to explain how it works is to look at a couple of scenarios. In both scenarios, the offering period is one year long, there are two purchase periods, each 6 months long. The company gives a 10% discount through its ESPP.

Scenario 1: The fair market value of your company stock at the offering date is $140. The stock does well over the purchase period, and is now trading at $154 at the purchase date. You are given a 10% discount, and will be able to purchase shares for $126. While a non-employee that purchased the stock would have only seen a 10% increase in their shares, through the ESPP, you just got a 22% return ($126 à $154) in just 6 months!

Scenario 2: The fair market value of your company stock at the offering date is $140. The stock hits a rough patch over the purchase period, and is now trading at $120 at the purchase date. You are given a 10% discount on the lower of the two prices, in this scenario, the price on the purchase date. You will be able to purchase shares for $108. While a non-employee that purchased the stock would have seen a loss of 14%, through the ESPP, you still got an 11% return ($108 à $120) in just 6 months.

Now can you see what makes an ESPP special? If the stock price goes up during the purchase period, you win big. If the stock price drops, you still win. And if it stays flat? You still buy at a discount, and you still win. Before rushing to devote your whole paycheck to the ESPP, let’s review some contribution considerations.

Contribution Considerations

If you elect to participate in the ESPP, your company will open and automatically fund your personal ESPP account through payroll deductions. Cash accumulates in your ESPP account (often shown on your pay stub) until you reach a purchase date. At the purchase date, the account balance is used to purchase company stock.

For example, if you elect to contribute 10% to your ESPP, and you are paid a salary of $60,000 on a bi-weekly paycheck, it will automatically contribute $250 each paycheck to your personal ESPP account. After 6 months, the accumulated balance of $3,000 will be used to purchase company shares. Given the example in Scenario 1, it will purchase 23 shares at $126 each, and your account balance would be $3,542 (23 shares x $154/share).

Be careful when choosing how much to contribute to your ESPP. The percentage of income you elect to contribute is based on your pre-tax salary, not your take-home pay after all of your deductions. That means a 10% election will decrease your take home paycheck by more than 10%.

For example, continuing the example from above, pre-tax pay on a $60,000 salary would be $2,500 bi-weekly. However, after all tax deduction, it maybe something closer to $1,900. Deducting another $250 will be a 13% decrease in take-home pay, not 10%. This is exaggerated if you are also contributing to your retirement account. If, say, you are contributing $12,000 to your Roth 401(k), that would be $500/paycheck. Your paycheck is now $1,400, and a $250 deduction towards your ESPP will now be 18% of your take home pay.

Limits to ESPP Contributions

Finally, there will be an upper limit on your plan contributions, either defined by the IRS or by your plan. Plans will sometimes cap the amount or percentage of your income you can contribute, usually between 10 to 20 percent.

Even if you’ve got a fortune to invest, the IRS sets the upper limit of ESPP contributions. For 2019, you can contribute up to $25,000 worth of stock per year before taking the discount off the stock price. So if your employer offers a 10% discount off the stock price, the most you stock you’ll be able to purchase each year will be $22,500.

$25,000 worth of stock
-$2,500 (10% discount)
$22,500 (max contribution)

In this article, we’ve covered the basics of ESPP, how the discount works, and how to think about contributions. Another quirk to these plans is the way shares are taxed. In part 2 of this series, we’ll tackle the tricky taxes.

1 IRS rules state that companies cannot provide a discount greater than 15%.