- An employee stock purchase plan (ESPP) lets employees at publicly traded companies buy company stock at a discounted price.
- Employees can enroll in an ESPP by making contributions that are deducted automatically from their paycheck to save up until the purchase date.
- How ESPPs are taxed depends on whether it’s qualified or non-qualified — and whether you decide to sell your shares later.
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Landing a new job at a publicly traded company can be exciting. In addition to a 401(k) match and health insurance, publicly traded companies may also offer an employee stock purchase plan (ESPP).
What is an employee stock purchase plan?
An ESPP allows employees to buy stock for the company they work for at a discounted price, typically up to 15% off. Some companies offer ESPP as soon as you start, while others wait until you’ve been there for at least a year.
If you truly believe in the company’s mission and that its value will grow, it might be beneficial to hold equity — another word for shares or ownership — in the company that you work for.
Your employer’s plan might have a limit on how much you can purchase, and they might also have a cap on what percentage of your take-home pay you can actually contribute, says Charly Kevers, chief financial officer at Carta, an equity and ownership management company. “The IRS currently doesn’t allow the employee to purchase more than $25,000 worth of stock per calendar year through ESPP,” he adds.
How does an employee stock purchase plan work?
An ESPP allows you to buy stock in the company you work for through automatic post-tax paycheck deductions. Up to 15% of your paycheck after taxes and retirement deductions gets automatically deposited into an account held by your employer brokerage during the offering period, the period of time between starting ESPP and the purchase date. At the end of the offering period, all the money you saved will be used to buy the stock at the agreed-upon price.
“Similar to a 401(k), you choose how much you want to contribute. Your company takes that amount out of your paycheck post-tax and holds onto it. Then, on designated purchase dates, your employer uses that money to purchase and issue shares back to you,” says Kevers.
The IRS limits you to a maximum contribution of $25,000 for 2022, although your employer may cap your contributions further or even as a percentage of your income.
Example of how an ESPP works
For example, let’s say you start working at Company ABC Inc. and it offers its employees an ESPP, and its shares are currently trading at $100. If you choose to participate, the ESPP might allow you to buy 100 shares at $85, which is 15% lower than the current price of $100. No matter how much the price of the stock increases at the time of your purchase date, you’ll still be able to secure 100 shares at the price of $85.
If you plan on buying 100 shares of Company ABC Inc.’s stock at $85 and your purchase date is in two years, you might ask your employer to hold $177.08 per month from your paychecks to cover the $8,500 you need to buy those 100 shares.
How are ESPP stocks taxed?
How your ESPP is taxed depends on what type of plan you have. “There are two types of ESPPs, which affect tax treatment,” Kevers says. He recommends checking in with your employer to see if they offer qualified section 423 ESPPs or non-qualified ESPPs.
Here are the key differences:
You might pay less in taxes with a qualified ESPP, but there are more restrictions
Kevers explains, “If you have qualified ESPPs and you hold your shares at least one year after your purchase date and two years after your offering date, you’ll pay ordinary income tax on the difference in price between the discounted price and the offer date price. The difference between the offer date price and the final sale price is treated as long-term capital gain or loss.”
According to Fidelity, US tax law states that employees cannot be taxed on profits because of the discount. Going back to our Company ABC Inc. example, if the price of the company’s stock is $125 by the time of your purchase date, you’re looking at a total profit of $4,000. However, only $2,500 of your total profit can actually be taxed.
Quick tip: According to the US tax law, an employee cannot be taxed on any gains accrued from the discount they receive on the stock purchase price.
If the stock was valued at $100 during your offering date and you sold your shares at $125, you’ll be taxed only on the difference between those two prices. However, a holding period will be required to reap those tax benefits.
If you hold onto that stock for one year after your purchase date and two years after your offering date, says Kevers, you’ll have to pay long-term
capital gains
taxes on the $2,500 profit that you made. Depending on your income, long-term capital tax gains are usually lower than the ordinary
income tax
rate.
“If you don’t hold qualified shares for at least one year, you pay ordinary income tax on the difference. The spread between the sale price and purchase date fair market value is treated as short-term capital gains,” says Kevers.
Non-qualified ESPPs are less restrictive, but you pay more in taxes
On the other hand, non-qualified ESPPs aren’t as complicated or restrictive as qualified ESPPs, but you may end up paying more in taxes.
“If you have non-qualified ESPPs, you pay taxes on the difference between the value of the shares at purchase and the price you paid when you purchase the shares,” says Kevers.
Using the Company ABC Inc. example again, you’ll have to pay taxes on the total profit of $4,000, though the main benefit over a qualified section 423 ESPP is that you can sell the stocks at any time.
What happens to my ESPP when I leave a company?
If you leave your job after the purchase date, your shares can be sold or transferred to your personal broker.
Just keep in mind that during the offering period, you haven’t actually purchased stocks yet. The offering period is the time that your employer holds contributions from your post-tax payments to use on the purchase date.
“During the offering period, the individual will be exited from the plan and given a refund of the monies contributed to that point,” says Kevers.
ESPPs vs 401(k)s
Generally, an ESPP is not a replacement for a traditional retirement plan, like a 401(k) or Roth IRA. An ESPP is similar to buying individual shares of stock in the market to sell at any time, while a 401(k) or Roth IRA is specifically for retirement purposes to be withdrawn later in life.
“Employees might consider consulting a financial advisor for their particular situations. A 401(k) or IRA tends to be invested in a basket of stocks — it’s more diversified — whereas an ESPP only allows employees to purchase stock in their employer,” says Kevers.