Employee Stock Purchase Plans (ESPPs)

If you work for a publicly traded company, they may offer you an employee stock purchase plan (ESPP) as part of your benefits package. An ESPP allows you to invest money directly from your paycheck, after taxes, into your company’s stock and pay less per share than the stock’s fair market value (i.e., the price everyone else would pay), called an offer, or grant, price.

To understand more about ESPPs and if taking advantage of your employer’s ESPP makes sense for you, keep reading.

Qualified vs. nonqualified plans

The two categories of ESPPs are qualified and nonqualified. Qualified ESPPs are the most common and must follow eligibility criteria set by the IRS. Important details include: all plan participants have equal rights in the plan, the offering period (explained later) cannot exceed 27 months, and the stock discount cannot exceed 15%.

Nonqualified plans are simpler but there is no tax advantage of any kind. For these reasons, the rest of this article will focus on qualified plans.

Enrollment

Like other benefit plans—retirement, healthcare, etc.—employees must enroll in an ESPP plan during the open enrollment period. You will choose how much of your paycheck you want to contribute to the plan, which is usually limited by the employer to 10% of your take-home pay and limited to $25,000 per year by the IRS regardless of employer restrictions.

Company match

A company may offer an ESPP match, where they will match your contribution dollar for dollar or based on a set percentage. So, if you contribute $100, the company could contribute $100 toward purchasing stock, or they might match up to 50%, and so contribute $50.

Purchase discount

Many plans are structured so that employees pay a discounted rate, rather than full price, for stock. This usually ranges from 10 to 15%.

Purchase period and lookback provision

After each pay period, an employee’s deferral (the amount chosen to be withheld from each paycheck) is put into a separate account, held and managed by a transfer agent or brokerage firm, until the stock purchase date. The time between purchase dates is called the purchase period and is set by the company—it could be monthly, quarterly, twice a year, or some other frequency.

A lookback provision ensures employees will pay the lowest price for stock during that purchase period. If during the purchase period everyone else paid the prices of $10, $22, and $42 per share, you as an employee would receive shares at the lowest price of $10.

Companies can also offer the previously mentioned stock discount (up to 15%) on top of a lookback provision.

Vesting schedule

Like with retirement plans, ESPPs come with vestment schedules. All this means is that even if you choose to participate in an ESPP plan from day one of employment, you won’t have full ownership of that stock to sell right away. In the first year, you might own 25% and in the second year 50% until you are fully vested at 100% after four years of employment.

Selling

Selling your ESPP stock will trigger a tax event—either you will pay taxes on any profit you made based on the earned income (also called compensation income) tax rate or the capital gains tax. Determining which tax rate you pay—and in what proportion—depends on how long you’ve held the stocks.

ESPPs can be a wise addition to your investment portfolio, especially if your company offers a matching program and/or a lookback provision on top of a purchase discount. Just be sure to keep your investment assets diversified—no one wants to relive the Enron scandal.