# Employee Stock Purchase Plan (ESPP) Is A Fantastic Deal

If you work for a publicly traded company which offers an Employee Stock Purchase Plan (ESPP), you’ve got yourself a fantastic deal. An ESPP typically works this way:

1. You contribute to the ESPP from 1% to 10% of your salary. The contribution is taken out from your paycheck. This is calculated on pre-tax salary but taken after tax (unlike 401k, no tax deduction on ESPP contributions).
2. At the end of a “purchase period,” usually every 6 months, the employer will purchase company stock for you using your contributions during the purchase period. You get a 15% discount on the purchase price. The employer takes the price of the company stock at the beginning of the purchase period and the price at the end of the purchase period, whichever is lower, and THEN gives you a 15% discount from that price.
3. You can sell the purchased stock right away or hold on to them longer for preferential tax treatment.

Your plan may work a little differently. Check with your employer for details.

The 15% discount is a big deal. It turns out to be a 90% annualized return or higher.

How so? Suppose the stock was \$22 at the beginning of the purchase period and it went down to \$20 at the end of the period 6 months later. Here’s what happens:

1. Because the stock went down, your purchase price will be 15% discount to the price at the end of the purchase period, which is \$20 * 85% = \$17/share.
2. Suppose you contributed \$255 per paycheck twice a month. Over a 6-month period you contributed \$255 * 12 = \$3,060.
3. You will receive \$3,060 / \$17 = 180 shares. You sell 180 shares at \$20/share and receive \$20 * 180 = \$3,600, earning a profit of \$3,600 – \$3,060 = \$540.

Percentage-wise your return is \$540 / \$3,060 = 17.65%. But, because your \$3,060 was contributed over a 6-month period, the first contribution was tied up for 6 months, and the last contribution was tied up for only a few days. On average your money is only tied up for 3 months. So, earning 17.65% risk free for tying up your money for 3 months is equivalent to earning (1 + 17.65%) ^ 4 – 1 = 91.6% a year.

90%+ a year return is fantastic, isn’t it? That’s when the employer’s stock went down. Had the stock gone up from \$20 at the beginning of the purchase period to \$22 at the end, your return will be even higher at 180%!

[Update on May 30, 2008]: I created an online spreadsheet on Zoho. You can plug in your own numbers and calculate the annualized return. The annualized return is what a savings account will have to offer in order to match the same return from an ESPP. Even at 5% discount without lookback, an ESPP is still equivalent to a 20% APY savings account.

What should you do if your employer offers an ESPP? Participate to the MAXIMUM allowed as long as you can sell the stock soon after the stock is purchased.

Should you hold the purchased stock longer for preferential tax treatment? No! On the typical 6-month purchase program, you will have to hold on to the stock for additional 18 months in order to get preferential tax treatment. If everything goes well, you can reduce the tax on your profit from say 35% to 15%. In the above example, that will save you \$540 * 20% = \$108. But if your employer’s stock goes down 3% during the 18 months you are holding the stock, because your entire \$3,600 is at stake, the tax benefit will be completely wiped out. You already earned 90% annualized return on the purchase. Holding on for another 18 months and hoping the stock won’t go down 3% is really penny wise pound foolish.

More technical details about ESPP on the web:

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1. Flexo says

Timely article. My company just began offering ESPP. The purchase period is three months, so there are 4 purchases each year, at a 15% discount of the price at either the beginning or end of the quarter. Our stock price is at the highest its ever been (IPO was in late 2001), but no matter what happens, it’s an automatic 15% increase each quarter. I’ll be investing the maximum 10% of my salary, and ofsetting the missing cash flow with savings each quarter. We can sell immediately, but I’m a designated employee, so I may have to way to until an open trading window is declared.

I’ve written about it on my blog

This is an outstanding post. It’s so good that I’ve quoted you liberally in a post on the same topic on my blog:

Psychohistory

I’m definitely going to subscribe to your feed.

One minor nit. Your analysis on the “3 month average” is not quite right. You should do a discounted cash flow on the paycheck contributions, and then calculate the internal rate of return on the investment over the 6 months. When I did this (see my blog post), I got a 98.4% return, making the assumption that he got paid every 2 weeks.

Thanks for the great post! Loved it.

3. Harry Sit says

Thank you Adam for the compliments. With regard to the exact return, I didn’t want to get too technical. After you understand the return is over 90%, it makes very little difference whether it’s 91% or 98%. If you really want to be exact, you also have to take into account the 3-business-day settlement period and a typical \$20 commission on the sale. For more fun with math, check out this post:

TIPS Pricing Is Complex

4. ricemutt says

Nice article. I wrote one a few months back on this exact topic, and it’s interesting to see we have the same advice/approach. I’ve talked to many friends who don’t seel until they can get preferential tax treatment, or do nothing with ESPP shares in their account at all.

In my own personal experience, the companies who’ve offered ESPP have had big downside risks to maintaining their share price over 18 months’ time. They’re in some trouble, or they’re high-growth stocks whose prices are fairly volatile, and all have been tech companies. Holding might work out sometimes, but to me, it’s better to have the “free” money than risk it another 18 months or so.

• erin says

Going back a long way on this…you still there?

I am enrolled in my company’s ESPP and plan to sell the shares as soon as I am able. However, would it make any sense to sell the equivalent amount of older shares that I already have that wouldn’t be subjected to short-term gain taxes?

Looks like our low prices for ESPP will be ~\$17, and I have some 8 year old shares at \$13. Would it makes sense to keep the newly-purchases ESPP shares and instead sell the old shares?

• Steve says

If you’re going to hold on to shares of your employer’s stock either way, holding on to the newest ESPP shares for 2 years (long enough for a qualifying disposition at the long term capital gains rate) is probably the correct choice.

However, it’s really not recommended to hold any stock in your employer if you can avoid it. It’s too many eggs in one basket (both your primary income and a portion of your net worth).

5. espp_in_cincy says

I have a question regarding ESPPs. The 15% discount, is that a form of reportable income or do you just get that margin for free? I read an article on compensation income and disqualifying dispositions and it is still unclear to me.

6. Harry Sit says

The discount is reportable income. Your employer will track it and add it to your W-2 if you sell right away. Read the Fairmark link for more details.

7. Anonymous says

Your money is tied up for an average of 3 months (which is correct) – but you do not have the opportunity to purchase shares every 3 months – only twice per year.

Also, you need to consider the opportunity cost of not investing the money at a risk-free rate alternatively.

Shouldn’t the calculation of return on an annual basis really be 1 + 17.65% ^2, ~ 38.4% before factoring opportunity cost and before factoring tax effects.

I think you are overstating returns in your analysis above. That being said, ESPP’s are still great deals.

8. Harry Sit says

The math is correct. You get this opportunity to earn 17.65% in exchange for tying up your money for 3 months. Even if you only get this opportunity once a year, the annualized return on the opportunity itself is still ~90%. The fact that you get to do this twice a year only means you get to earn ~90% annualized on more dollars. Adam in comment #2 said it should’ve been even higher at 98%. I made a spreadsheet for bi-monthly payrolls and I also added a \$20 commission for the sale and 3 business days settlement delay. It came out to 87% annualized when everything is taken into consideration. You can look at the spreadsheet if you are interested.

~90% annualized versus risk free return of 5-6%, both taxable, I’d take the former any day. I wish I could do this on 100% of my salary.

9. Anonymous says

Great article, very useful. I just started with a new company and learned about their ESPP. Instead of a 6 month purchase period, however, I’ve been told the stocks are bought monthly and contributions are met by the employer on a monthly basis by 25%. In this case, when would be the best time to sell?

Thanks!

10. Anonymous says

This math in this article is crap. ESPPs are excellent, but not for the reason quoted in the article. The 90% annualized return is ficticious and over-hyped (its even bolded and colored red to draw attention). It seems to be intentionally misleading (or even worse, unintentionally misleading). You may think quoting an annualized return is useful, but it is absolutely incorrect to apply it in this context. Using XIRR() and quoting the 90% return is reckless and dangerous to your readers.

The fact is you get a 17.65% return after 6 months of investing. You can’t arbitrarily say your money was tied up for 3 months on average and then annualize the 6 month figure by raising it to the 4th power! Furthermore, there is no compounding effect from ESPPs, you recontribute the next 6 months. At least use your math within the framework of the ESPP. The reality is that you get 17% return on half your dollars after 6 months, and then 17% return on a different half of your dollars, 6 months later. This equates to a 17% annual return.

Imagine a 12-month CD with return of 5%. You can’t say that on average the money was tied up for 6 months, and then use the year end 5% return to calculate an annualized return from the 6 month point! This would be like saying 1.05^2 is your annualized return .. but we already know the real annual return is 5%!

To further prove my over-hyped point, assume a single payment of -\$255 on 1/15/2007 that you can immediately flip on 1/18/2007 for \$280 (with \$17 cost, \$20 sale, and \$20 commission like your example). Using Excel’s XIRR() on that produces an annualized return of 8746485%! Amazing right? Well not really .. it doesn’t mean anything! I suppose it would be more credible if I colored it red and bolded it.

11. Harry Sit says

Time and the rate of return are related. If it takes 1 year to earn 5%, it’s 5% rate of return per year. If it takes 10 years to earn 5%, the return is a lot less. Same with time frames shorter than 1 year. If it takes 3 months to earn 17.65%, the rate of return is a lot higher than what you’d earn if it takes one full year to earn 17.65%. With your CD example, if the CD allows you to deposit \$100 a month and then gives you \$1,260 at the end of the year, the return is a lot higher than a CD which asks for \$1,200 up front and gives you the same at the end of the year.

12. Anonymous says

I wonder if you can give an opinion on some tangled up issues with my ESPP. (I have totally screwed up by treating these shares as regular stock.) I’ve been transferring shares for several years into my son’s ugma account (using gift-splitting with my spouse in some cases). I’ve only now realized that I need to declare income on the 15% discount for qualifying dispositions. Do I also need to declare a long-term capital gain at the time of gift? I thought the stepped up cost basis (original cost plus declared ordinary income) would be passed along to him as with typical gifts of stock. Thanks in advance for you help. I enjoy reading your blog.

13. Harry Sit says

Fairmark has very good writeup on the tax treatment of ESPP dispositions. Please note the two links in the end of that article with more detailed info on both qualified and non-qualified dispositions.

Their book Consider Your Options covers both stock options and ESPP. It is an excellent resource.

14. Anonymous says

Thanks. I actually had some communication with Kaye Thomas about my issue. Her site is a great resource; I think I will buy the book.

It takes about a week for the shares to actually hit my account, and that week where your shares have been bought but you can’t sell them define your risk window. I eliminate this risk by shorting the shares right away and then covering when the shares hit my account. It is lock solid, no risk, guarenteed return. As long as you are allowed to sell your shares right away, you are a moron for not taking out the absolute maximum you can. If you cant afford the money taken out of your check, borrow it.

16. Miguel says

TFB – great article – I encourage my friends to take advantage of ESPP for just these reasons, even though our company has just changed things up a bit recently. We get a 15% discount off the period-end price only, no looking back to the start price anymore. That said, I’ve seen share prices fluctuate (ok, drop) dramatically just after the ESPP buy date, perhaps caused or aided by a flood of selling immediately after all my colleagues and I take control of new shares. I remember reading somewhere that companies with ESPP plans are supposed to buffer this effect somehow. Do you know anything about that?

17. Harry Sit says

Miguel – No I don’t know anything about companies buffering the effect of employees selling shares acquired from ESPP. Depending on the trading volume of the company’s stock, what employees sell can be a very small percentage of the overall volume even if all employees sell right away.

18. Deb says

hmmmm, the advice to sell immediately has been followed religiously by a number of my co-workers, in this case to their detriment.

I suppose if your company doesn’t meet the basic Buy & Hold investment criteria because it’s not a great company with great management, fear or a decline in price would dictate selling immediately. However, if your company is worthy of a long term investment decision (other than the guaranteed short-term payoff offered by immediate ESSP share disposition), consider the following:

In the 10 years I’ve been employed in the rock-solid no-debt firm which employs me, I have participated in our ESPP to the 15% max. The average price for the first 3 years was below \$10. For the next few years, it averaged around \$35, then underwent a 2:1 split. Over then last few years the share price has quadrupled again. Sure, during the decline there were days/weeks/months that some shares were under water for a while, but since I viewed it as a long term opportunity, I wasn’t worried. Buy & Hold. So shares that I purchased for \$10 that my friends sold 7 years ago for \$11.50 out of fear that the price would go down would be worth about \$140 each now.

My advice: Don’t treat ESPP any different than any other investment. Stay in if it makes sense, get out ASAP if it doesn’t.

19. Deb says

oops, make that “fear OF a decline in price would dictate selling immediately”

20. choppy says

Hi TFB,

I’d love to see a refresh of this blog post.

A lot of changes I see:
1) discount lowered from 15 to 10%
2) offering price is no longer the lower of the beginning or ending offering period price
3) new tax laws on short term vs long term capital gains tax
4) markets are volatile and declining…think HP! ouch!

Yet my savings account still can’t muster anything beyond 1%! so any tips/strategies for optimizing ESPP in 2010 and beyond would be greatly appreciated.

21. Harry Sit says

choppy – The calculator still works. Just enter 10% as the discount and look at the result for “without lookback”.

22. Dru says

Question…I have signed up for the maximum of 474 shares @ \$18.00/share with my company. We are now trading at approx \$28.00/share. I opted for a lump sum payment instead of payroll deduction. I can pay for the 474 shares on the 1st or 15th of the month, then sell at \$28.00 (or whatever it is trading) about 3 days later.

I am netting approx \$10.00/share, so am I paying taxes on the difference? Would this mean that if the above scenario were done, I would be crazy not to do it? It looks like that if you even had to borrow the money for a 10 day period, it would be worth it (unless the stock totally crashed)

Am I right.

Thanks in advance for the replies.

23. Harry Sit says

Dru – You are right. It would be crazy not to do it in the scenario you described. Yes you pay taxes but you still get to keep a big portion of it after taxes.

24. Ed says

My company is offering ESPP starting 1/1/2011. Like some of the other comments, I have issue with the effective annualized return rate. I do agree the annualized return on part of the investment is ~91%, but the investment does not compound. Consider the following:

Total amount invested in six month period: \$10,000.00
Shares sold with no change in stock price: \$11,764.71 (1/0.85 gain)
Net six month gain \$ 1,764.71

Repeat for next six month period — total gain = \$3,529.42 = (2 * \$1,764.71)

Average daily amount invested for year: \$5,000.00
Percent gain for 1-year: \$3529.42 / \$5000.00 = 70.59%

NOTE: 70.59% = 4 * 17.65% (within rounding error)

Am I missing something?

25. Harry Sit says

Ed – See comment #11. Getting paid \$ 1,764.71 every six months is different from getting paid \$3,529.42 every twelve months. Anyway, whether it’s 71% or 91%, it’s still a fantastic deal, isn’t it?

26. ajdj says

too good to be true – you get 15% real return (after inflation) but not more

the problem with TFB’s logic is he/she is confusing average investment (or money tied up as it is called in the article) with the initial investment required in this case. In some cases you can use that as a proxy for example if you have a broker account and you put in money on 15th of the month then at the end of month your return can be calculatd this way by treating the investment as being half (or the holding as being half month which should give similar results). However in this case the initial investment is not half of your eventual purchase amount unless you think your future salary is worth nothing in today’s dollar. (most of us think \$1000 I am getting in two weeks is pretty close to \$1000 I have today). so what is your initial investment then? it is your each paycheck deduction for ESPP discounted to the grant date – this is your committed investment on day 0 (you can get technical that you can still get out of ESPP before purchase but you can’t get the return either in that case). Unless you future salary is worthless to you you probably won’t get 90% or 70% return in this case. Given today’s low discount rate your initial investment will be very close to your purchase amount in 6 month if you use the short rate as your discount rate (you can argue to use a more subjective discount rate e.g. your personal consumption discount rate) The confusion comes from how you defined the money invested and how you treat investment committed in the future in this case. if you carry a balance on credit card or have mortgage you should know this – future obligation is still obligation so is future investment. so if you use inflation rate as your discount rate to calculate your initial investment, then ESPP is naturally hedged against inflation – meaning you get a 15% real return after inflation assuming you sell it right away. no work for 15% real return – still a very good deal. By the same logic you don’t get the return compounded or added, because your second purchase is on different future earnings. (the anonymous post on 12/26/2007 has the right intuition but did not state the logic correctly). why don’t all the people do this? you should do this if you can afford it or if you can borrow at a rate lower than 15% – so if you have to run up your credit card balance to do it then it is probably not worth it, but you can use your 5% mortgage loan to finance it.

27. Grace says

Right now my company has a 6-month purchase period where I sell immediately after the period is over. My company is moving to a 24-month discounted purchase lock-in with up to 4 purchase periods. I’m not sure what my strategy should be with this new plan. Please advise. Thanks!

28. Harry Sit says

@Grace – Can you elaborate on what it means by “a 24-month discounted purchase lock-in with up to 4 purchase periods”? Say a purchase period starts on Jan. 1, 2012. You buy on what date? July 1, 2012? At what price, and then what? When can you sell, Jan. 1, 2014? What about the second purchase period? Also mandatory hold until Jan. 1, 2014?

29. bucky says

@Anonymous on December 26, 2007
“The 90% annualized return is ficticious and over-hyped”

I know this was an old comment, but I just read this blog. The 90% may be overhyped, but it’s certainly not fictitious. What it means is that if you put the amount you set aside for ESPP in a savings account, that savings account would have to give you a 90% annual interest rate to match it.

“To further prove my over-hyped point, assume a single payment of -\$255 on 1/15/2007 that you can immediately flip on 1/18/2007 for \$280 (with \$17 cost, \$20 sale, and \$20 commission like your example). Using Excel’s XIRR() on that produces an annualized return of 8746485%! Amazing right? Well not really .. it doesn’t mean anything!”

It does mean something. It means that you should definitely flip that \$255 into \$280 before investing into your eventual investment.

Do this exercise, if you saved 10% of your monthly salary into a bank account that gave 17.6% interest rate, how much would you have at the end of the year? Compare that if you had put the 10% into an ESPP.

30. Grace says

Elaboration on “a 24-month discounted purchase lock-in with up to 4 purchase periods” (comment #27)…
* Enrollment in the August 1, 2011 Offering Period will allow participants to lock-in a purchase price based upon 85% of Company’s closing stock price on August 1, 2011, for up to four (4) purchase periods.
* ESPP participants will purchase shares every 6 months at 85% of the lower of the closing stock price on either August 1, 2011 or on the Purchase Date.
* The Offering Periods under the ESPP will overlap; that is, new Offering Periods
will begin under the ESPP while other Offering Periods are already underway.
Participants may lock-in a share purchase price at the beginning of the Offering Period in which they become enrolled.
* The ESPP has an auto-reset feature that automatically resets to a new 24 month Offering Period if the stock price at the start of any new Offering Period is lower than it was at the beginning of the Offering Period in which the participant is enrolled.

I don’t think there is a mandatory hold. If I understand this new plan correctly, I should still sell immediately after each 6-month period, right?

31. A Different Mark says

@ bucky on July 27, 2011
The 90% Annualized Return (IRR) is a meaningless numerical trick. What we’re really interested in is what sort of interest rate you’d have to get (probably called ROI) from a bank to equal the benefits of ESPP.

If you put \$1000 into ESPP over a six-month period, in equal payments, we all agree that you get \$1176.50 back at the end. Suppose you do that again for the second half of a year: you put out another \$1000 and get back another \$1176.50. You end up with \$2353.00.

Now, suppose that, instead of contributing to the ESPP, you put the money (again, as equal biweekly payments) into a bank offering a 35.3% annual interest rate. Your ending principal would be \$2000; your average balance over the year would be \$1000 (let’s ignore compounding, though it helps my point). \$1000 at 35.3% gives a \$353.00 credit, so your ending balance would be \$2353.00 — the same as the ESPP. This proves that the *meaningful* annual return is 35.3%, not 90%.

32. Bucky says

@A Different Mark:

I completely get what you’re saying. But you are mis-applying what “annualized return” means. Annualized return is the same as APY (annual percentage yield), which is a standard calculation that banks use for savings accounts and CDs. I don’t hear anyone claiming that APY is a meaningless numerical trick. Let me give a few examples to make my point:

1. Let’s compare your examples over a 10 year period. If you put in \$1000 into ESPP every 6 months over 10 years, you would end up with \$23530. That’s an absolute gain of \$3530, which is a total percentage gain of 17.65%, which comes out to an annualized return of 1.64%. According to your logic, would you would be better off putting your money into a bank account with 2% annual interest rate rather than ESPP?

2. Which would get you more return:
A. Jan-Jun: put \$1000 in bank at 35.3%. July-Dec: Put \$2000 in bank at 35.5%
B. Jan-Jun: put \$1000 in ESPP. July-Dec: Put \$1000 in ESPP, \$1000 in bank at 35.5%
The answer is to simply compare the APY. That’s the purpose of APY.

People seem to get stuck on the fact that ESPP is only a 6-month period, therefore annualized return/APY is meaningless/fictitious. Look, the whole point of APY is to normalize the return over a common period. It doesn’t matter what the length of the period it. If you get stuck on this, simply re-do all your calculations for a monthly-percentage-yield or 6-month-percentage-yield. The bottom line is that for a 6-month period, the only way you can beat ESPP is to find an investment that can give you > 90% APY.

33. xswalden1 says

The comments remind me of the government regulation on payday loans. When they looked at APY for loans, when including fees, etc. The APY was 250-1000%. Just as the prior comment correctly state that the standard calculation terminology is APY. The below link maybe an interesting read for some.

http://www.in.gov/dfi/2366.htm

34. Myster says

My company matches with 15% at the end of the quarter (the quarter where I purchase the shares) and another 5% at the end of the year if I don’t sell the stock. Do you think it’s worth holding for the entire year?

35. Josh Maher says

Good post, although I am suprised that you haven’t outlined a covered call strategy in relation to an ESPP. I have found that combining the two together is an incredible multiplier – although I do agree that you need to be doing something else with some other portion of your investment…

http://joshmaher.net/2012/01/16/you-have-an-espp-now-what/

36. jeff says

Excellent explanation! My company has an ESPP but trying to decipher what it means is impossible.

37. Kris says

Just a couple questions , (my employer offers the ESPP but no discounts are given) I have weekly deductions come from my paycheck to purchase shares usually by the next business day , however lately it seems as though my employer is not immediately investing the funds , but suspending them in a pending state ? Some years ago my Employer took over the ESPP and removed Merrill Lynch , what I wanted to know was ,
1) How is an employer able to legally maintain operation of an ESPP on a large scale without violating ethics with respect to obviously knowing what contributions will be made on what day and time pertaining to t
heir Stock ?
2)Would there be any time limit that a company would be obligated to invest the funds that have been transferred , or could they just wait an sit on it (collecting interest, or invest it themselves in a separate account while it only displays “Pending” to the owners until they’ve made a few bucks and return it or should I say invest it but at a higher rate than it could’ve been , thereby gaining two fold ?
3) Is there any authority they must present how investing takes place ?

38. Harry says

Kris – If there are no discounts given, there doesn’t appear to be a reason to participate. After all you can buy however many shares you want on your own whenever you want (blackout policy notwithstanding). I don’t know the answer to your questions. They are best addressed to the stock admin department at your employer as to when the shares will actually be purchased and handed over to you.

39. sam says

I know this article is old. But, the math in it is horribly wrong. The annual return rate is not 90%+, it’s more like 4% annual effective on a net basis (NOT 90%). I’ll show you why below.
Suppose you earn \$80k/yr. You can contribute 10% of your salary per year or \$8k/yr. For simplicity, suppose you invest every pay period and there are 24 pay periods. You invest \$8k/24 = \$333.33 every ~15 days. The price of the underlying stock for which you get a 15% discount doesn’t really matter (what will matter later is its volatility). And, assuming you sell it immediately the reference stock price is \$60 per share. This means you buy it at \$60 * .85 = \$51 per share. Since, every quarter you invested \$333.33 * 6 = \$2000, you buy \$2000 / \$51 = 39 shares (you can’t buy fractions of shares). You sell them right away at \$60. You get \$2340. You’d say to yourself, I invested \$2000 and got \$2340 back plus I have \$12.94 uninvested. So, I made almost 18% return! But, then again, you’d be wrong. Lets get to the details: When you sell, you incur commission cost, usually around \$20. Also, you trigger taxs (the 15% discount is taxed as ordinary income, and the gains are taxed at short term capital gains tax rate which can be higher than ordinary income depending on the state you live in), we’ll assume you pay these taxes quarterly too (as the law requires). And, we’ll factor in the time value of money (\$1 now is worth more \$1 in 1 year).
Over the course of 1 year, you’d run through this series of cash flows at ~15 day intervals:
intervals 1 – 5: -\$333.33
interval 6: -\$333.33 + \$2340 (stock sale) + \$12.94 (uninvested cash) – \$20 (commission) – \$118 (fed tax and ny state short term capital gains tax) = \$1881
lets explain the tax bill of 118. You get taxed gains (\$2340 – \$2000 – \$20) * (.25 + .09) = \$118. The 25% is federal and 9% is about the NYC tax on capital gains (varies by state).
repeat these 6 intervals identically four times (remember, stock price doesn’t matter much)
The internal rate of return of this cashflow is just over 4%. A far cry from the claimed 90% annual return.
Note, this also assumed that the stock price doesn’t fall before you can sell it. If it does, two things fall, you’re gross returns and the taxable portion. But, the net return is squeezed nonetheless. Buy and sell or buy and hold with caution. And, don’t lie to yourself thinking you are gaining 90% returns.

40. Harry says

Sam – I don’t know how you did your math. Putting your cash flow series in a spreadsheet with XIRR, I get 160%. It’s higher than the 90% because you are assuming selling every quarter instead of every six months.

1/15/2013 -333.33
1/31/2013 -333.33
2/15/2013 -333.33
2/28/2013 -333.33
3/15/2013 -333.33
3/31/2013 1881
4/15/2013 -333.33
4/30/2013 -333.33
5/15/2013 -333.33
5/31/2013 -333.33
6/15/2013 -333.33
6/30/2013 1881
7/15/2013 -333.33
7/31/2013 -333.33
8/15/2013 -333.33
8/31/2013 -333.33
9/15/2013 -333.33
9/30/2013 1881
10/15/2013 -333.33
10/31/2013 -333.33
11/15/2013 -333.33
11/30/2013 -333.33
12/15/2013 -333.33
12/31/2013 1881

XIRR(B1:B24,A1:A24) = 160%

That’s how much a bank savings account would have to pay after taxes in order to deliver the same cash flow.

41. sam says

Great job Harry! I didn’t use a finance calculator and just plugged it into excel and used the irr function assuming it assumed all inputs were evenly spaced within one year. As it turns out, it assumes that all inputs are one year apart! So, the above calculation of 4% assumes a stupid 24 year cash flow cycle, hahahaha! When I annualized the IRR result (1+4%)^24 – 1 = 160%. You’re right!
I verified xirr gives the same result with date input. Thanks for teaching me man!

42. sam says

Harry, I want you to look through this. Using the same assumptions as before except that the taxable portion should really be only \$113 (the un-invested amount shouldn’t be taxed). So, with this modification, the annual IRR is 166%. Ok, does that seem meaningful? That is, we fixed a calculation error with net impact of \$20 a year and the IRR shoots up 6%. What is the marginal utility of \$5 per quarter for a person earning \$80k/yr?
This person invests \$8k/yr and gets back \$8,877.32 net of taxes and fees. Layman return of 11% over the year. Compare that to the 166% IRR the cash flow analysis gives. Why I think using the layman return rate is more useful in this case is volume. If I find a penny on the floor, my annualized return rate is freakin’ positive infinity. If I put in 25 cents in a slot machine and get two quarters back, my annualized return is more than 205427259098698000000.0% (but excel can’t handle the actual calculation, the number is too big for excel). So, my point is that volume is too small to boost 160% or even 90% returns, though, they technically be true. You can see that \$877 extra net dollars spread out over 1 year isn’t bad, I’ll take it any day, but it’s not going to significantly affect this persons quality of life.
So, for practical purposes, I’d say ESPP is a good deal that practically gives you at a 1% annual pay raise.

43. Harry says

Sam – I agree it’s not going to make you rich because of the limit on how much you can put in. However, the high IRR shows it’s a great deal that everyone should contribute to the maximum allowed and that selling right away is already good enough. Those are the two points I tried to drive home.

44. Kevin Timothy says

Author,

Thank you much as this is a very well written piece of
information. I just became eligible and I have never had
crystal clear. My main concern was when I can actually
“purchase” the stock. I wasn’t aware that there is a period,
and that it varies from company to company.

45. Steve says

What if you can’t sell the stock right away? I work at a company with an ESPP, but you’re required to hold the stock for 6 months before you can sell it. The annualized return would be to 30% or less – and that’s if you assume the calculation still applies, since there’s far more risk involved.

• Aaron says

Steve:

That’s simple. Short an equivalent amount of the stock when you get your ESPP shares. Then, at the end of 6 months, use the acquired shares to cover your short position.

• Steve says

Thanks for the response. Shorting employer stock is against company policy. However, as far as I can tell trading in options is allowed. Often (I don’t know how often) companies that prohibit shorting company stock, also prohibit effectively shorting company stock via options.

46. Harry says

It isn’t as clear-cut but I would still participate. It’s possible to lose money in one cycle but chances are it will be made up in other cycles. Investing in a diversified portfolio can lose money in six months too. After all, only a small amount of money is being held at any point.

47. Sam R says

Harry, this is a great post. My ESPP gives 15% disc, bought every 6 mo. Currently have \$5700 in it.
Currently tax bracket is 25%. By January next year we’ll have retired early (I hope) and be in 10% tax bracket (coz living off savings is enough).
Next sale day is October. Should we sell the next day after purchase date or wait 3 months until January 2015 to sell?
Thank you, Harry. I always like your posts.

48. Alfred says

Harry,

My companies ESPP discounts 15% with a monthly offering period with no holding limits. I just sold half my shares which were held for 2yrs so qualified disposition. The company stock doubled over that time. Which is good, but now I have to figure out the tax for each 24 blocks of stock purchases….I think I have it figured out.

For the remaining shares in disqualified position, should I sell those and then each month sell? Also, there is a max 20% should I just max that out since I’ll be taking the immediate 15%?

49. matt says

My company offers a 12% discount (no look-back) with offering periods lasting 2 months and no minimum holding period. Modifying your spreadsheet, I calculated an annualized rate of return of 195%! (assuming \$140 contribution per pay period, 5 business days from the end of the period until sale, and \$30 commission) This seems like a ridiculously high ROR, but when you consider a 12% return over a months time, it makes sense. I’ve always held onto my shares for 2 years from the beginning of the offering period to have the added benefit of being taxed at the long term capital gains tax rate, but I will probably start selling immediately after based on your post here.

50. JoeTaxpayer says

I saw the reference to this article from your email update today. Funny, really. I tried to explain this very thing years ago to co-workers, and they didn’t get it either. It’s not tough. A 15% discount is a 100/85 = 17.65% return. That return is not annual, but on an average 3 months you are out of pocket on that money. 1.1765^4 is an annualized 91.57%.
Now, one response here was right, you can’t start the year with \$1000 and end with \$1915.70. But that’s another matter.
What’s important is to understand the return the money is subject to. “I can’t do ESSP, I’m paying off my 18% credit card.” That 18% or annualized 19.6% rate is the apple to apple number. Put that \$300/mo to the ESSP and when you sell in 6 months, you’re ahead of what you’d have saved on the card interest.
In a different world, where the amount invested didn’t betray one’s salary (because we were allowed to do 15% of gross income), I’d have simply offered to fund the non-participants myself. Give them the monthly dollars they said they couldn’t afford, and after 6 months, split the profits. Good article, Harry, keep them coming.

51. Chris says

Your article is helpful. I particularly appreciate your explanation of the benefits holding it for preferential tax treatment, i.e., there are little. (Another respondent’s comments about treating it as any other investment make sense, as well. However, being heavily invested in the company that employs you amplifies your overall financial risk.)

The spreadsheet would be more helpful if you used data validation to show drop-down boxes for different pay cycles and holding periods. The calculation fields could use if statements to adapt to user data entry.

52. Nick says

My ESPP is a discount of 15%, over 6 months, with no look back, and a max of 25k yearly.

If my company offers an ESPP but also has a blackout period that I am affected by (but not the whole company) what additional considerations should I take? I’m assuming length of additional time I’m forced holding the stock but at what point does the risk out weight the reward? Is there any calculations out there I should look at? My concern is everyone who is not affected by the blackout will sell lowering the stock price before I can sell my shares.

My second question is about 401k vs ESPP. I confirmed that my ESPP contribution is POST tax after my 401k contribution has been taken out. I always max out my yearly 401k and my company offers a match of 50% of your contribution up to a maximum of 6% of eligible compensation. Should I consider lowering my 401k contribution in order to get a bigger ESPP contribution? Although because it is two 6 month windows there would be no way to do this for both windows and still get my max 401k contribution. I guess what I am asking is which is better maxing out my 401k contribution or putting more into my ESPP account?

I will look into if shorting is allowed by my hunch is that it is against company policy.

Thanks

• Harry Sit says

Nick – The ESPP is deducted after tax, but calculated as a percentage of pre-tax income. Your 401k contributions don’t affect how much is deducted for ESPP.

53. Nick says

Thanks for the reply below is what I got from my Company which I believe supports your theory.

“Yes, it is after your 401k contribution. If your ESPP contribution was \$150 per paycheck and before the ESPP contributions start in payroll you “take home” \$1,000 (including 401k), then your revised take home pay will be \$850. “

54. john smith says

I thought I was making out like a bandit with my ESPP until I did my taxes this year. Please correct me if I have this wrong but here is a simplified version of my scenario:

Number of shares: 100
Grant price: \$110
Exercise fair market price: \$100
Discount: 15%
Exercise price paid: \$85 (\$100 * (1-.15))
Value of discount: \$1500 (\$15 * 100)

Sale price: \$90
Proceeds: \$9000 (\$90 * 100 shares)
1099 Basis: \$8500 (\$85 * 100 shares)
Gain: \$500 (\$9000 – \$8500)

However:

W2 reports the discount as income: \$1500 (\$15 discount * 100 shares)
Corrected basis: \$10,000 (\$100 * 100 shares)
Gain: -\$1000 (\$9000 – \$10,000)

If the discount is reported in the W2 as income then it doesn’t seem like there is any discount at all. To avoid a loss you need to make sure the sale price is at least the exercise price plus any commission.

• john smith says

On further consideration, this is nonsense. The short term capital loss offsets a portion of the compensation income so you still come out ahead until the stock sell price falls to the discounted price.

• Chris says

@John Smith: ignore all the discount rates. Just use XIRR in Excel, as above.

Record investments on pay dates and net sale revenue as of the date it’s deposited in your checking account.

Calculate income tax on the discount amount reported on your W2, using your marginal rate. (You might have to calculate how much reported income is from the discount.) Record that in your spreadsheet using the date you get your refund or pay your additional taxes.

What’s the XIRR?

55. Steve says

I sold some ESPP shares (disqualifying disposition) on 12/31/2014 but my employer did not add the ordinary income part of the sale to my 2014 W-2. Instead they put it on my 2015 W-2. I am no tax expert but I’m pretty sure the income is taxable in the year in which the shares were sold, including the ordinary income part. Can you tell me if I’m right about that?

• Harry Sit says

Sorry, I don’t know. Maybe they went with the settlement date?

56. Andy says

While I wholeheartedly agree with the message of maxing out ESPP because of the 90% return (I’ve been telling colleagues to do this for 20 years), I must disagree with the advice to sell immediately. I think your reasons for doing so can be summarized as Loss Aversion. You claim that just a 3% loss would wipe out your tax benefit. I would argue so what? If you sell immediately, you lose your tax benefit with 100% certainty. Any investment can go down 3%. But no investment other than holding your ESPP guarantees a 1.76% boost (from tax savings) that you add to whatever other movement the stock makes. I have a spreadsheet of my ESPP experience with my company since 1998, and I have saved over \$7,000 in taxes by waiting the 18-month period for each sale. This is in addition to over \$29,000 in appreciation and over \$4,000 in dividends during the holding period. Yes, there were periods in which I lost principal by holding, but also periods in which I gained big. But let’s ignore the \$29K and the \$4K, because arguably I could have gotten that from any similar stock or ETF with similar price movements. The \$7K in tax savings, however, I had no other way of achieving.

Let’s look at your example. You take the \$3060 and buy \$3600 worth of stock. Your profit and your taxable amount is \$540. Let’s say you are in the 25% marginal tax bracket (which is where your assumed income puts you). Your tax owed is \$135. If you hold for 18 months, your tax owed is only 15%, or \$81. You stand to save \$135-\$81 = \$54. So, what is \$54 worth over 18 months? Well, it is 1.76% of your original \$3060 investment. So, if the stock goes up 5%, you actually gain 6.76%. If it goes down 5%, you will lose money, but not the full 5%. Why? Because you still owe less tax. So, in the case of the 5% loss, you have a 5% capital loss (from the FMV of the stock), but you still have the tax savings of 1.76%, so your net loss is only 3.24%.

Let’s say the stock had 50% chance of going up or going down. So, now think about a coin flip that on heads gives you \$6.76, and on tails makes you pay \$3.24. You’d be stupid not to flip the coin. Selling the stock immediately is like saying “I don’t want to take that coin flip” which is tilted in your favor.

Anyone who would throw away a 1.76% boost to their investment gains is letting fear preside over sound math. And psychologists have a name for it. It is an irrational behavior called Loss Aversion.

And to colleagues who say they must sell because they need the money now, I answer, that if they can just find a way to make it for 18 months one time (delay a big purchase, or something) that they can create a pipeline, in which every 6 months they are selling stock that is 18 months old, so they are never without the income. There is just an 18 month buffer that they are pulling from. They can even do this gradually, by (let’s say) only selling 1/2 of the unqualified stock for immediate needs. Eventually they can build the buffer up until they never have to sell unqualified stock for immediate bills.

But that said, I find that many people I talk to succumb to loss aversion. One bad 6 month period with a loss, of say 20%, and they are Same Day Sale forever. I can only shake my head in wonder as I look at my spreadsheet. The spreadsheet doesn’t lie, and doesn’t have emotions. Very few investors can say the same when the feet hit the fire.

• Andy says

To be consistent with the article, I should state the 1.76% gain over 18 months as 1.18% annualized.

• stannius says

The discount part of the gain is always taxed as ordinary income (with an exception for a qualifying disposition if the sale price dropped below the pre-discount price you paid). Only the gain from a lookback provision will have favorable tax treatment if you wait for a qualifying disposition.

• stannius says

Therefore, if your plan doesn’t have a lookback provision, you are definitely better off selling immediately.

If the stock falls during the offering period, but rises during the holding period, it’s actually better to sell it as a disqualifying disposition than a qualifying one!

Furthermore, if the stock does fall while waiting for a qualifying disposition, the loss could be disallowed as a wash sale, if you’re still participating in the ESPP at the same employer. You might need to hold on to the stock an extra 31 days to avoid that. It’s not the worst thing but it’s a hassle, and tends to build on itself – a disallowed wash sale ends up adding to the basis of the new lot, making a loss on that lot more likely.

So this might suggest a rule of thumb if you do have a lookback provision:
if there was a gain during the offering period, wait for a qualifying disposition.
if there was a loss during the offering period, wait 31 days to avoid a wash sale, then sell.

57. Michael says

For the sake of my inner math nerd, please don’t promote incorrect math.
There is no compound interest, so there should be no taking anything to a power. It’s 17.65% * 4, not 1.1765 ^ 4.

Here is my explanation (same as #24):

I put \$5,000/13 = \$385 aside every two weeks, for six months. So since my money invested grows linearly, on average I have \$2,500 invested for six months. At the end of the six months, I sell, and get my minimum return of 17.65% on \$5,000, which is \$882.
Since on average, I was only half-invested, I can say that my return is \$882 / \$2,500 = 35%, just for this semester (not annualized).

But now it’s time for some important facts:
At the end of the first semester, I cannot reinvest my winnings. In fact I can only repeat what I did last semester: invest my maximum percentage (10% of my salary).
So I have \$882 of profit in-hand, but I can’t invest that into my ESPP! And I can’t keep my \$5,000 contribution invested either! I have to start over!

So I start over and do it all again: I gradually invest \$5,000 (\$2,500 on average), and get my minimum \$882 of profit again. And the cycle begins again.

Let’s look back on what happened: over the year, I had \$2,500 tied up on average. And over that year, I made \$1,765 in profit.
That comes out to an annualized rate of return of \$1,765 / \$2,500 = 70.6%

That is a GREAT return on investment, which is what makes ESPP a no-brainer, even against credit card debt. But that doesn’t mean we can use just whatever math to get to that conclusion. Please update your post, for the sake of good math.

• Harry Sit says

If a bank offers a savings account with the same cash flow pattern, what kind of APY must it have for you to favor the savings account? That’s the question here. For the same reason a payday loan is said to have 400% APR when it charges \$15 to advance a small amount for two weeks. Whether you renew the loan or not, it’s still 400% APR.

• JoeTaxpayer says

Re-read my comment number 50. Part of what you are saying is true, one can’t actually see that full return over a year, but that’s not what annualizing is about.

Here’s what is true. Any time you borrow or pay back a loan you have interest from one day to another, and you can annualize that number. Your stock went up 10% in a week? Good for you, that annualizes to 14,104% return. Of course you won’t see that, unless you can achieve that gain another 51 times.

In the case of the ESPP, the 90%+ is what you’d see if you did the IRR calculation on a spreadsheet. It also shows you why you should choose this over even paying back a high interest credit card. Save via the ESPP, and every 6 months, pay the card back with the profits.

The math is 100% correct. The implication is up for discussion.