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Although it is company-specific, what are your experiences when contributing to ESPP (Employee Stock Program)?

More specifically, do you recommend contributing to ESPP in max? Or maybe it is only worth during certain times throughout the year? (stock prices are usually higher during Spring/Summer times!)

I work in a big cable company in the US. Kind of stable company. My company rules:

10% of salary with 15% discount, happening quarterly, vesting after a year from purchase

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One ESPP I am familiar with also offers a 15% discount on stock and a max of 10% of salary. Deductions are taken from each paycheck and stock purchases are made twice a year. It also has the feature that the 15% discount is applied to the lower of the stock price at the beginning or end of the period.

For contributions made at the beginning of a period, this gives a minimum annualized return on investment of about 38%. For the final contribution of the period, the return is 1,143,160,976%, according to this calculator https://www.calculator.net/roi-calculator.html. (Invest $85 for 4 days and receive $100.) The return averaged over the 6 month period is over 90% APR.

Those returns are based on the assumption that the stock goes down during the period. If the stock goes up, the return is even higher, since the purchase price is less than 85% of the current price at the end of the period.

Conclusion: It would be crazy not to take advantage of this opportunity. The only risk is that the stock plummets between the time it is purchased and the time you sell it. For the risk averse, the company offers automatic sale 1-2 days after the purchase.

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  • "the company offers automatic sale 1-2 days after the purchase." -> that's quite a bad advice tax-wise, assuming that the stock price has increased. – Franck Dernoncourt Mar 7 '19 at 6:08
  • @Franck, I agree, but many people feel that they shouldn’t invest at all in their own company, so they provide thus option. – prl Mar 7 '19 at 6:37
  • @Franck, also the discount is always taxed as regular income; it can’t be treated as long-term gain by holding for a year. (It’s still bad, tax-wise, but perhaps not quite as bad.) – prl Mar 7 '19 at 6:39
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    Selling the shares the moment they become yours comes with no risk and a guaranteed gain. Selling the shares after they become yours can lower or raise your tax burden, but also comes with the risk of holding your company's stock. Some companies have minimum holding periods after the ESPP shares become yours, but many do not. You can minimize risk by selling as soon as you can (realistically, you can't sell them the moment they become yours, but you may be able to sell the next day, before the price has moved too much.) – pft221 Mar 7 '19 at 6:41
  • "For contributions made at the beginning of a period, this gives a minimum return on investment of about 38%." Do you mean this is a 38% annualized return? – Acccumulation Mar 7 '19 at 16:17
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Downsides:

    -ESPP can be a significant hassle. After a few years, you can have dozens of different stock purchases, each at a different cost basis.

    -ESPP significantly reduces the diversification of your portfolio. Not only is a large chunk of your money in one stock, it's your employer, and your employer's stock price and you continuing to have a job are probably positively correlated.

    -You're tying your money up. ESPP programs generally have a vesting period, and even if they don't, if the stock goes up you need to hold on for it for a year to claim the profit as long-term capital gains. If you're not already planning on putting large chunk of your income away in savings, it may not be a good choice. If you have high-interest debt, you are likely better off paying that off before participating in ESPP.

Upsides:

    -It ties your money up. Although I just listed this as a downside, it can also be an upside. An ESPP program means that your employer is handling putting your money into stocks for you. Humans are loss averse, so getting $(X+Y), and then losing $Y, feels worse than just getting $X in the first place. With ESPP, you're never seeing that money (other than in your gross pay), so you don't have to summon the will power to let it go. There's much less of a temptation of "oh, well, I can afford to splurge on this thing if I just don't put anything away in savings this month". You just get a lower take-home pay, you adjust to having that be how much you have to live on, and then when you retire it's "Hey, I have several hundred thousand dollars in this account! Awesome!"

    -The discount, obviously. If you get a 15% discount on 10% of your income, that's 1.5% of your income. If you work 2000 hours a year, that's 30 hours of income. So the question is: are you willing to deal with the downsides in exchange for what's basically four days of paid vacation?[1]

More specifically, do you recommend contributing to ESPP in max (10% of salary with 15% discount)? Or maybe it is only worth during certain times throughout the year?

Generally speaking, ESPP is either a good thing, in which case you should put in the max, or the downsides outweigh the advantages, in which case you shouldn't put any in. There aren't many cases where going half in, or dong it only some parts of the year, is the optimal choice. The tax hassles of keeping track of all the purchases is about the same regardless of how much you put in.

[1] It's probably actually 1.76%. That's because if you can spend 10% of your income buying stock at a 15% discount, then you can get stock worth 10%/.85 = 11.76% of your income, so there's a bonus of 1.76% of your income.

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  • I don't think any ESPP has a "vesting period." Some have a minimum holding period. – stannius Mar 11 '19 at 16:51
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I have so far declined to participate in my own company's offering. We also had a 10% maximum contribution, but our discount was only 5%. Further, in order to get the favorable tax handling, we had to (I believe) hold the stock for 18 months after purchase before selling.

(The following is my understanding, which is not necessarily entirely correct.)

You don't pay any taxes until you sell the stock, but how you are taxed depends on how long you hold the stock. A qualifying sale takes place at least one year after purchase and at least two years after the offer date.

  1. The entire gain on a non-qualifying sale is treated as ordinary income, on which is assessed federal and state tax, plus SS and Medicare (and I'm not sure if that means just your contribution or your company's as well). There is some difference between how non-qualifying sales and qualifying sales are taxed. What that difference is, precisely, is unclear to me.

  2. On a qualifying sale, ordinary income is only realized on the discount between your purchase price and the fair market value at that time; any other gain is treated as a long-term capital gain. Note if the stock goes down, this means you still treat the entire discount as ordinary income, even if that is greater than your net gain, but you can recognize a capital loss as well.

Whether or not it makes sense for you to participate depends on

  1. Your willingness or ability to defer salary
  2. Whether you are willing to sell immediately to collect what amounts to a 1.5% bonus.
  3. Whether you think the stock price will increase enough to make it worth deferring the sale even longer, based on when you sell and how much you ultimately sell for.
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  • It is not quite true that "The entire gain on a non-qualifying sale is treated as ordinary income." The discount is ordinary income and the gain between FMV at purchase and sale price is capital gains. That said, short term capital gains are taxed at the same rate as ordinary income. – stannius Mar 11 '19 at 16:52
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    The federal income tax rate is the same, but no SS/Medicare is assessed on a short-term capital gain, and state taxes, if any, may vary. – chepner Mar 11 '19 at 16:59
  • Can you comment on the difference between a qualifying and non-qualifying sale, then? I thought the difference was in what was considered a capital gain and what was not. – chepner Mar 11 '19 at 16:59
  • That is the difference indeed. Here is a good article explaining it financialgeekery.com/2012/05/15/… – stannius Mar 11 '19 at 17:29
  • Even I had a mistake in my comment. I should have written "[In a disqualifying disposition] The discount is ordinary income and the difference between FMV at purchase and sale price is a capital gain or loss." – stannius Mar 11 '19 at 17:29
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TL;DR: In most cases, for most people, it is financially preferable to participate in your employer's ESPP if the discount is 15%.

Details:

do you recommend contributing to ESPP in max (10% of salary with 15% discount)?

It depends on your other investment options, on your expectation in the evolution of your company's stock price, and how much diversification you aim to have in your portfolio.

For example, if you expect your company's stock price to stay constant and you don't have any other investment yielding 15%, then you should contribute to your employer's ESPP. You should also factor the tax rates (as mentioned by prl, the discount is always taxed as regular income, which may mean taxed twice more than long-term capital gains, for example).The amount of contribution depends on your diversification target.

Or maybe it is only worth during certain times throughout the year?

That depends on the accuracy of your estimation of the evolution of your company's stock price and your other investment options. Note that many (all?) ESPP plans specify "You may decrease your contribution percentage, suspend your contributions, or withdraw at any time subject to plan requirements. However, you may only increase your contribution percentage during the enrollment window. Please note that increasing your contribution percentage will move you to a new offering period and result in a new lock-price." so you may not have that much choice regarding whether to contribute to the ESPP only during certain times throughout the year.

In most cases, for most people it is financially preferable to participate in your employer's ESPP. Quote from {1}:

Although an average employee stands to gain $3,079 annually, only 30% of individuals take advantage of this risk-free opportunity.

More information on the tax rate for ESPP: https://turbotax.intuit.com/tax-tips/investments-and-taxes/employee-stock-purchase-plans/L8NgMFpFX (mirror):

How much of the stock sale price is compensation (ordinary income tax rate) and how much is long-term capital gain? That depends on whether your stock sale is a qualifying disposition or a disqualifying disposition.

Disqualifying disposition: You sold the stock within two years after the offering date or one year or less from the exercise (purchase date). In this case, your employer will report the bargain element as compensation on your Form W-2, so you will have to pay taxes on that amount as ordinary income. The bargain element is the difference between the exercise price and the market price on the exercise date. Any additional profit is considered capital gain (short-term or long-term depending on how long you held the shares) and should be reported on Schedule D.

Qualifying disposition: You sold the stock at least two years after the offering (grant date) and at least one year after the exercise (purchase date). If so, a portion of the profit (the “bargain element”) is considered compensation income (taxed at regular rates) on your Form 1040. Any additional profit is considered long-term capital gain (which is be taxed at lower rates than compensation income) and should be reported on Schedule D, Capital Gains and Losses.

What's the difference between a 1040 and W2 (mirror): The W-2 is the form your employer sends to you each January reporting your wages & withholding. The form 1040 is your tax return you file.

References:

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    I disagree with this answer. The 17% guaranteed return overwhelms any other possible investment options. The only concern would be if the company enforces a significant holding period on the stock that is purchased. – prl Mar 7 '19 at 5:58
  • @prl did you read the last part of the answer "In most cases, for most people it is financially preferable to participate in your employer's ESPP. "? Also where did you see the "17% guaranteed return"? – Franck Dernoncourt Mar 7 '19 at 6:01
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    @FranckDernoncourt The 17% guaranteed return comes from the 85% discount on the purchase price. (1/.85 = 1.176 -> 17.6%). This, of course, presumes the ability to sell at the moment of purchase--so any mandatory holding period matters. – pft221 Mar 7 '19 at 6:26
  • @prl Got it. Still I stand by my answer, which is "It depends on your other investment options, on your expectation in the evolution of your company's stock price, and how much diversification you aim to have in your portfolio. [...] In most cases, for most people it is financially preferable to participate in your employer's ESPP. ". and in practice pretty much the same as yours, since indeed it's difficult to find better investment options. – Franck Dernoncourt Mar 7 '19 at 6:32
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    OK, yeah. Qualifying sales recognize ordinary income on the discount and long-term capital gain/loss on the rest. Non-qualifying sales recognize ordinary income on everything. (Ordinary income incurs SS/medicare, though, which short-term capital gain does not, right? That would be independent of whatever the short-term CG rate is. State handling may also be different.) – chepner Mar 7 '19 at 22:09

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