17% Return in 1 second? — 3 Insane ESPP Tips
Your ESPP has the potential to give you a 17% return… in just one second. But there’s a catch: you could mess this up even when you’re contractually given massive benefits. So buckle up, as we uncover the thrilling truth behind ESPPs, how they work, and if you should even contribute.
What is an ESPP?
ESPP stands for Employee Stock Purchase Plan. It's a company's way to incentivize you, their employee, to stay at the company and be invested in their success by giving you access to their stock…Often-times with some sweet deals attached.
If you work hard and build the business, then you can directly benefit from the growth of the company. On the other hand, if you twiddle your thumbs all day, you might not have much of a payout.
ESPP Timeline
It's easiest to understand an ESPP chronologically. So here’s an overview of the timeline of your ESPP. There are 4 important time frames you should know about. We’re going to start with the first one, which is the time that gives you the potential to out-earn your coworkers.
Enrollment Period
The official title of this timeframe is the “Enrollment Period”. This is a period where you have to make a couple important decisions: whether or not to participate in your company’s ESPP (we’ll dive deeper on this later in the video) and, if so, how much of your gross income to contribute. Be aware that current tax laws cap the amount of company stock you can purchase through an ESPP to $25,000 annually
According to NASPP, most companies have under half of their employees contributing to their ESPP! (link). Most of your co-workers are underutilizing the potential available to them. So if you participate in your company’s ESPP, you're literally going above average and can likely out-earn your coworkers.
Offering Period
The second important time frame for ESPPs is the Offering Period.
This is when the enrollment period ends and the plan starts withdrawing that predetermined amount from your paycheck. A typical offering period lasts six months and—similar to a 401k— your contributions are withdrawn from your paycheck. But unlike a traditional 401k, your contributions are withdrawn after tax.
What if you have regrets during the Offering Period? Perhaps you are contributing a larger portion of your paycheck than you can afford. Your company may allow you to suspend, withdraw, or change your contribution percentage during the offering period, but every ESPP has different rules, so you’ll want to pay attention to yours.
Just know that, your contributions aren’t actually being used to purchase company stock yet. The company is holding your contributions on the side in a trust...waiting for the third important time: the Purchase Date.
We’re covering a lot of information, so to help you retain all of this, I’ve consolidated it into a FREE ESPP guide that you can download below.
ESPP Guide
Purchase Date
This is the day when the plan uses your contributions to actually buy company stock.
On this day you have as many taxes as I have friends... and because I have no friends, you don't have any taxes... I wish I were kidding. Haha! So there are no taxes on the purchase date for qualified ESPPs (aka 423 plans). Tax is deferred until you sell your stock which is the great thing about qualified plans. If you’re participating in a non-qualified ESPP (which is less common), any spread between the purchase price and the fair market value is taxed as ordinary income on the date of purchase, subject to withholdings.
Good news! On the purchase date, you’ll typically receive more benefits than just receiving company stock. It’s common for companies to offer three additional benefits for participating in an ESPP. Before we dive into these benefits, let’s quickly cover the last important time you should know… the date of sale (also known as the date of disposition).
Date of Sale
The great thing about this date is that you get to choose when to sell, which gives you a lot of flexibility and opportunities to strategize. The not-so-great thing about this date is that you’ll trigger taxes. The taxation of ESPPs is quite complex… I’ll get to that in a minute, but I mentioned those additional benefits for participating in an ESPP.. Let’s dive into those now!
Benefits
Lookback Provision
Companies with an ESPP plan often have what’s called a “lookback provision”. This provision allows you to purchase the stock at the lower of two prices—the price on the first day of the offering period OR the price on the purchase date. Buying low and selling high is the whole premise behind investing. So having the ability to contractually buy low can make a huge impact on your return!
Speaking of massive returns, if you’d like a return on your personal capital, subscribe to my YouTube channel.
Discount
In addition to the lookback provision, your company may stack another benefit on top…a discount of up to 15% off the purchase price of the stock. So not only are you getting the lowest price through the lookback, you could also be getting a discount off that price!
The best part is, a 15% discount from your ESPP doesn't actually mean a 15% return…it’s even more than that!
I polled my LinkedIn followers to show you how unintuitive this is. I asked them which they’d prefer to receive: a 15% return or a 15% discount. Here's the results.
I believe 80% chose the wrong answer...including financial planners, CPAs, PH.Ds, and other financial professionals. Here’s why I favor the discount over the return.
Let’s say I have $100 to invest. If I get a 15% return, I’ll pay $100, and gain $15…making my ending balance $115.
15% RETURN:
+ $100 investment
+ $15 return
= $115
In comparison, let’s say I still have $100 to invest, but I’m given a 15% discount. I’ll pay just $85 to own that $100 investment. As such, I immediately gained $15 of value. Plus, I get to keep the $15 that I would’ve otherwise spent on the $100 investment.
15% DISCOUNT (ESPP):
+ $85 investment
+ $15 of value (from discount)
+ $15 unspent cash
= $115
Even though the outcome is the same, I’d take the discount. Why? because it took less of my cash to get the same value. What’s more, the discount got me a larger return. Here’s how:
We just talked about how a $100 investment with a 15% return gets me $15.
$100 * 15% = $15
In the case of the discount, I only invested $85, but the stock was worth $100, so I got $15 of value. Here’s what everyone misses: what return on $85 is needed to produce that $15?
$85 * __% = $15
It can’t possibly be 15%. How could 100 * 15% be the same as 85 * 15%?
$85 * 15% ≠ $15
If you do the math, it actually requires a higher return for $85 to produce $15…a 17.64% return to be exact.
$85 * 17.64% = $15
So the investor who chooses a 15% discount gets a higher return for less money. I call that a win! Although a 15% return versus a 17.64% return may not be a huge difference, every little bit helps! I’d take a discount over a return any day!
80% of the people I polled don't understand that. To be fair, there was a lot of context left out of my poll, so I’ll give everyone a benefit of the doubt, but…I think it’s safe to say that you’ve now become above-average again. If you’re finding value in this, please hit the like button.
Okay, so now that we understand that it's a 17% return….
…how do you go about getting it in one second?
Assuming your company offers the max 15% discount, on the purchase date they’ll take all of your contributions made during the offering period , apply the 15% discount, and purchase stock. Does that mean that it’s a one second return? Yes…and no. Technically speaking, as soon as they apply the discount, there’s an immediate 17.64% return. It may not be realized gain, however…especially if you end up making some common mistakes that I’ll tell you about in just a minute.
Qualifying Disposition
But first, let’s talk about the third benefit you may receive by participating in your company’s ESPP. If you choose to hold your shares one year from the purchase date and two years from the first day of the offering period, then your taxes switch from short-term capital gains rates to the advantageous long-term capital gains rates. This is called Qualifying Disposition and it’s only available in qualified ESPPs.
So the three benefits are the lookback, the discount, and the potential for long-term capital gains rates through qualifying disposition. Much like a 401(k) match can be viewed as free money...the ESPP benefits also have the potential to give you free money. Of course, it’s not a guarantee, but you have a pretty good chance!
Yet, ESPPs aren’t all sunshine and happiness. Let’s look at some common mistakes people unsuspectingly fall into. Then we’ll talk about whether or not you should participate.
MISTAKES
Concentration Risk
Mistake number one is being over-concentrated in your company. Think about it, you may be overexposed to your company via your salary, stock options, RSUs, ESPP and so on…putting your income and your assets into a single, effective “basket.” If anything terrible were to happen to the company, you could lose your income AND the assets you’ve invested. Ouch! Please don’t make this mistake by forgetting the importance of diversification. If you're looking for a professional to help diversify out of a company in a tax-efficient manner, my firm specializes in this and we have some limited room for new clients. More information below.
Holding Period
Mistake number two is being unaware of a holding period or market volatility. After the ESPP purchases stock, some companies enforce a mandatory holding period in which time you’re unable to sell the stock. So by the time you’re able to sell, the stock price may have dropped…maybe so far that the lookback and discount were virtually useless in providing you any gain. Even if there is no holding period, you may not be able to sell immediately after the discount is applied. This is why your potential 15% contractual discount may not always translate to a 17.64% return—or any return at all. Investing involves risks and this is one of them. Depending on the volatility of the stock, a 15% price movement may or may not be likely in a short period of time, but past results don’t predict future performance. You can avoid this mistake and manage your expectations through a tip I’ll address in a minute.
Double Taxation
Mistake number three is double taxation. When you pay taxes, the discount is correctly reported as income on your W2. A problem arises, however, if your broker (such as E*Trade or Fidelity.) reports that same income on Form 1099-B. So avoid this mistake by paying attention to your cost basis on your 1099-B.You may have to make an adjustment to avoid double taxation.
Qualifying Disposition Trap
Mistake number four is falling into the qualifying disposition trap. There’s a little quirk in the tax system that can make the highly-coveted qualifying disposition cause you to pay more in taxes …not less. This trap occurs when a Qualified ESPP has a lookback provision and the stock price is lower on purchase date than on the first day of the offering period.
Participating when you can’t afford it
I'll address how to circumvent this mistake in tip number 1.
Should I Participate?
So with all of these mistakes looming on your mind, you may be a bit scared…thinking “should I even participate in my company’s ESPP?!” The correct answer is “it depends.”
Here’s when it might make sense:
You might consider contributing to an ESPP when it aligns with your values and goals.
You have a high risk tolerance and capacity.
And your finances are in order: (for instance, you’ve got an emergency fund in place, minimal low-interest debt, a healthy retirement savings, you’re already maxing out your company’s 401(k) match, you have sufficient income to meet your obligations, and other unique factors.)
While this isn't an exhaustive list, these are just a few things to get you thinking. Also, please remember that the information provided in this video is not intended to be a substitute for specific individualized tax, legal, or investment advice. As such, please work with your professional.
If any of those things don’t describe you and your current financial situation, then it might not make sense to participate in your company’s ESPP right now.
This isn't a permanent decision, but rather, you might consider delaying your ESPP contributions until later when it makes more sense.
Strategies
For those that participate, there are some strategies that can help you decide when to sell. Let’s talk about these strategies for a minute, then I’ll share my 3 ESPP tips.
Flip the Stock
The purpose here is to participate in the ESPP just to capitalize on the discount and lookback. You’re not interested in holding the stock…especially not for the long-term. So you sell the stock as soon as possible after the purchase date. There’s less time for the stock price to move if you act quickly, so you’re more likely to solidify the lookback and discount benefits. That being said, financial planning is about tradeoffs and with this approach, you surrender the advantageous long-term capital gains tax rates. Also, this strategy only really works if there isn’t a lengthy holding requirement imposed by your company.
Out of all the strategies, this one can make a lot of sense unless the lookback drastically reduces the purchase price…at which point Qualifying Disposition might be worth pursuing. That said, this approach probably isn’t for you if you want to hold the stock long term, your company has implemented a lengthy holding period, or you want to get the best tax rate through qualifying disposition. If you’re finding value in this information, please hit the like button.
Qualifying Disposition
Right off-the-bat, you need to know that this strategy only applies to Qualified ESPPs. While this one is focused on the better tax rate, it also means you’re taking on more risk since you’re holding the stock for longer. To get the long-term capital gains tax rate, you have to wait two years from the first day of the offering period before you sell. In that time, stock prices could drop to the point that the lookback and discount don’t provide you any advantage. Oh, and if your plan has a lookback provision, there’s a potential that you run into the qualifying disposition trap I mentioned earlier.
While this strategy has some major gotchas to consider, it can make sense for certain financial situations. Most of the time, however, I wonder if it’s really worth it for most people.
Split the Difference
This approach is right in the middle of the other two approaches. You’re not selling as soon as possible, but you’re not waiting for qualifying disposition either. This approach isn't necessarily recommended when compared solely against the other approaches. Why? It brings the added risk of losing the lookback and discount, but doesn't bring an added reward of a lower tax rate.
That said, your unique circumstance may warrant an approach like this. For example, it might make sense if you don't want to incur taxes in the year the stock is purchased, but you also don't want to wait for qualifying disposition. That’s what I call tax planning!
Tips
Tip 1: Remember, you can partially participate
Your two options aren't “max it out” or “don't participate at all”. Taking advantage of the ESPP benefits doesn't have to make you broke. If you're early in your career working on a starter's salary, having ESPP contributions pulled from your paycheck can make your budget extra tight. What’s more, you might not be able to back out of the ESPP for 6 months. You should consider your cash flow and only participate when you can afford those contributions being pulled from your paycheck. You can start with smaller contributions and build your way up over time.
Tip 2: Evaluate your financial situation holistically
As you make decisions surrounding your ESPP, don’t just pay attention to the tax ramifications…because that’s not the most important consideration when making financial decisions. In fact, there are two things to look at before taxes: your values and goals and your risk tolerance and risk capacity. If you’re making financial decisions based solely on the tax implications, you’re doing it wrong. You need to know what you value in life, what your goals are and how your finances will help you achieve them, how you feel about taking on risk, and if you’re even able to take on risk financially. Once you’ve fleshed out those important considerations, you can start looking at taxes.
Tip 3: Read the ESPP document
This doesn’t have to be a big time commitment, just highlight the important information. Not every discount is 15% and not every enrollment period is 6 months. So understanding the rules of your company’s specific ESPP is crucial for making good decisions. These rules are the foundation upon which you build strategies and avoid making mistakes—because one single day could make a huge difference in your tax outcomes.
This line represents potential sale prices, and beneath it shows the potential tax outcomes for your ESPP depending on when you sell. Let me show you how you can successfully navigate ESPP taxes in this video right here.
