What Is an Employee Stock Purchase Plan (ESPP)?

How Do Employee Stock Purchase Plans Work?

ESPPs are generally a helpful benefit that might increase your total compensation by allowing you to set aside money, purchase your company's stock at a discount and then sell it for a quick profit. However, you'll want to review the program's rules before participating.

Eligibility and Enrollment

At many companies with ESPPs, most full-time employees will be eligible to enroll. However, you need to enroll during specific enrollment windows and may need to meet plan-specific eligibility rules.

• Plan-specific rules: Employers can choose to limit eligibility for ESPPs, and you might not be able to enroll if you've been employed for less than two years, are a seasonal employee or have a part-time role. Highly compensated employees and employees who own more than 5% of the company also might be prohibited from participating.
• Limited-time enrollment windows: If you're eligible for the ESPP, you need to enroll during one of your plan's enrollment periods. There may be several of these periods each year.

You may be able to change your contribution amount during each enrollment period. Or, some plans allow you to make additional changes throughout the year.

Contributions

Once you enroll in the ESPP, you start making automatic contributions to your account.

• Money comes out of your paycheck: Similar to other employer-sponsored benefits, such as a 401(k) or health insurance, your company will take your ESPP contributions out of each paycheck.
• Contribution limits: Federal tax laws limit the amount you can contribute to an ESPP to $25,000 each calendar year, based on the fair market value of the company's stock. Your company may also limit how much you can contribute based on a percentage of your paycheck. For example, you might be limited to contributing 15% of each paycheck, even if that won't lead to contributing $25,000 for the year.

The money you contribute gets set aside in an account that you don't control. However, if you need the funds, your ESPP may allow you to withdraw the money before the next stock purchase.

Offering Periods and Purchase Periods

The money you contribute to the ESPP accumulates and will be used to purchase shares at specific points throughout the year.

• Money accumulates during the offering period. The ESPP will have an offering period, which may begin at the same time as the enrollment period or after the enrollment period ends. The offering period could be up to several years long.
• You buy the company's stock on the purchase date. Within the offering period there may be several purchase periods. For example, an offering period might last for 12 months but there could be purchase periods every six months. The purchase date may be the last day of the purchase period.

The differing offer and purchase periods can be especially important if your plan has lookback provisions.

Discount Rates and Lookback Provisions

Some ESPPs offer discounts and lookback provisions that can increase your potential earnings.

• You might receive a discounted share price. Many ESPPs allow you to purchase the company's stock at a discount—15% is common. For example, if your stock is trading at $100 per share on your purchase date, you'll pay $85 per share instead.
• The discount applies to the lower share price. If your ESPP has a lookback provision, the share price you'll pay could be the lower of the price at the beginning of the current offering period or purchase date.

Say your company's stock is selling for $100 at the beginning of the offering period. Six months later, at the end of the next purchase period, the stock is up to $150.

If you receive a 15% discount and a lookback provision, you may be able to buy shares for $85 each—15% less than the $100 per share price. If you're allowed to sell the shares immediately, you can make $65 per share ($150 minus $85).

Selling Your Shares

The shares you purchase through the ESPP will be held in a brokerage account. Once the shares are yours, you can choose to hold onto them or sell them.

• There may be a holding period. Many companies allow you to sell the shares immediately, but some have minimum holding periods.
• Your company could have trading windows. Your company may also have specific trading windows—periods when you're allowed to purchase or sell the company's stock.
• There are tax implications to consider. Your profits may be taxed differently depending on how long you hold onto the shares before selling.

Qualified vs. Non-Qualified ESPPs

Although many ESPPs work similarly, your employer may set up a qualified or non-qualified ESPP.

• Qualified ESPP: This ESPP complies with IRS 423 regulations, can offer a discount of up to 15% on share purchases and you won't owe taxes on the discounted amount when you purchase the shares. There may also be additional tax benefits if you hold the shares for at least two years.
• Non-qualified ESPP: Companies don't have to follow IRS regulations to offer non-qualified ESPPs, and they may offer discounts of more than 15%. However, the discounted amount gets taxed as ordinary income when employees purchase shares.

Most ESPPs are qualified, but you can check with your company before signing up to be sure.

How Are ESPPs Taxed?

You include your earnings from participating in an ESPP on your tax return, but the tax implications can depend on the type of ESPP and how long you hold onto the shares. You may want to review the details of your situation with an accountant, but here are a few basics:

• Contributions are made on a post-tax basis. Unlike with a 401(k), you don't receive a tax benefit for contributing to your ESPP. It's more like setting aside money that you contribute to an ordinary brokerage account.
• The discount is treated as ordinary income. If you receive a discount, the discounted amount is treated as ordinary income. You include this income when you make the purchase with non-qualified ESPPs, or when you sell the shares if you're part of a qualified ESPP.

ESPP sales may be called qualified or non-qualified dispositions depending on how long you wait before selling your shares. These are different from the qualified or non-qualified ESPP plans, and the waiting period can affect your taxes.

• If you sell the shares within one year of the purchased date or two years of the offer date: Selling the shares quickly results in a disqualified disposition. Your profits are considered short-term capital gains and taxed the same as your ordinary income.
• If you hold the shares for at least one year from the purchase data and two years from the offering date: Holding the shares before selling them results in a qualified disposition. Your profits may be taxed as long-term capital gains, which could have a lower tax rate than your ordinary income.

You may also receive additional tax documents, such as a Form 3922, if you participate in your company's ESPP. Be sure to share these with your tax preparer or review them closely if you're filing your own tax return.

Are Employee Stock Purchase Plans Worth It?

An ESPP could be worth contributing to if your employer offers a discount or lookback provision and you don't need the money for day-to-day expenses.

In spite of potentially paying more taxes on the profits, some people choose to immediately sell the shares they purchase to claim the profit from the discount—and potentially from the lookback provision. Holding the shares might lead to a lower tax bill, but the share price could also rise or fall during that time.

If you sell the stock, you could invest the proceeds in a more diversified manner. Or, put the money into a high-yield savings account to earn interest.

Plan for Your Financial Future

Although an ESPP can be complicated to understand at first, participating may be a relatively easy way to increase your income. You can also look for other employee benefits that might help you manage your finances, such as free financial coaching or advising sessions.