If you work for a publicly-traded company that offers an Employee Stock Purchase Plan (ESPP), you’ve got yourself a fantastic deal.
How ESPP Works
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 that period. You get a discount on the purchase price, say 15%.
3. The employer takes the price of the company stock at the beginning of an offer period and the price at the end of the purchase period, whichever is lower, and THEN gives you the discount from that price. This feature is called a lookback. Some plans only use the price at the end of the purchase period without looking back to the price at the beginning of the offer period.
4. 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 Discount Is a Big Deal
A 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 six 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 six-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 six-month period, the first contribution was tied up for six months, and the last contribution was tied up for only a few days. On average your money is only tied up for three months. So, earning 17.65% risk-free for tying up your money for three 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%!
Online Spreadsheet
I created an online spreadsheet. 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 a 5% discount without a 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.
Sell After Purchase
Should you hold the purchased stock longer for preferential tax treatment?
No! On the typical six-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’re holding the stock, the tax benefit will be completely wiped out because your entire $3,600 is at stake.
You already earned a 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.
Further Reading
More technical details about ESPP on the web:
- Designing and Implementing a Section 423 ESPP on FindLaw
- Guide to Employee Stock Purchase Plans (ESPPs) by Kaye A. Thomas of Fairmark (I strongly disagree with Mr. Thomas about his objection to flipping ESPP shares. The risk of holding the stock is too high.)
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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.
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.
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. “
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?
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?
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.
Michael says
Harry, please update this article to reflect the math in Ed’s comment #24.
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.
James says
Really eye-opening post! I always thought that the ESPP was for suckers who didn’t understand basic portfolio diversification. Clearly, I hadn’t given this enough consideration.
My company offers a 5% discount on 3 month purchase periods without look-back. Certainly not as enticing as some others with higher %’s or look-back, but the shorter than normal purchase period is a positive. Modifications to the calculator to reflect 3 month purchase periods seem to net me out at 43.29% IRR.
However, I’m also considering redirecting additional disposable income to a Mega Backdoor IRA. Given that the money we’re talking about here is all after-tax, and the gap offered in my plan isn’t as stark as others, I’m better off filling up the Mega Backdoor IRA first before touching something like this, correct?
Andy says
I’m not sure that an IRA beats a 43% IRR. You might want to set up the ESPP as a pipeline for living expenses. It might take some temporary reduction of your megabackdoor IRA (via your 401k, I presume is what you’re talking about) while you get the first 3-month ESPP period filled up. But then when your 3 months is up, you could sell the ESPP non-qualified and put it in your bank for living expenses. From then on, your ESPP cashouts help fund living expenses, allowing you to put as much of your salary as you can afford towards the 401k for your megabackdoor IRA. So, you are still living on that portion of your salary, you are just piping it through ESPP for a 5% boost.
The math will, I think partly depend on your tax rate and how long your backdoor Roth has to grow before you’ll need to start using it. If you’re 20, it will have decades to grow tax-free. If you’re 60, you may be accessing it soon, so the 43% instant IRR may be a better deal.
I’d run some spreadsheets with assumed growth and tax rates to see how the Roth compares to having the money in your taxable accounts via the ESPP pipeline.
In addition, it may be worth paying current bills out of taxable accounts (drawing down savings) to be able to increase the amount of your paycheck that goes to the megabackdoor.
Harry Sit says
I agree with Andy. You only have to come up with enough money to fund one round of ESPP purchases. After the first round you use the sales proceeds to fund the second round. So your mega backdoor Roth is only interrupted temporarily.
James says
Andy, TBF,
Thanks for your comments. I’m 30, so I’d have a good bit of time for savings to grow in my retirement fund.
I’ve since contacted my ESPP plan provider and they weren’t able to verify how long I needed to wait for the shares to vest following the purchase period, but felt that it would be at least a few weeks (not a few days). I have to wait until the next sign-up period (quarterly) to verify for sure, but assuming that’s the case, it likely pushes me out of my risk tolerance since our company is in a challenged industry right now and isn’t doing so well.
Appreciate the feedback.
Andy says
I’m surprised to hear about a vesting period for ESPP. I have never heard of one. I know they are typical for things like Incentive Stock Options, Nonqualified Stock Options or Restricted Stock Units. Ours typically take 2-5 days to get from the company to the broker, and are then available for immediate sale. Hopefully the delay before you can sell is only a short window. Because if so, there is really minimal risk to your money of a drop between buying and selling. If they drag it out with a vesting period longer than a week or 2, that seems wrong to me. I’d be curious to hear whether anyone else has a vesting period on their ESPP stock.
Steve says
I had an ESPP with a 6 month required holding period before you could sell it. Also in a challenged industry. I hemmed and hawed but ending up deciding the gains were worth the risk.
Marco says
My company used the closing price for this last purchasing period even when the starting price was lower, are they able to do this?
Harry Sit says
If the program never had look-back or it had it but the program rules changed, yes.
Justin says
Hi Harry,
I was wondering if you could help me with the math behind my employer’s ESPP.
The employee handbook basically states that you can make after-tax contributions between 3% and 15% of your base salary, and that after one year of participation, you will be rewarded by receiving a matching quarterly contribution that will purchase additional shares of Company stock and will be credited to your account. The company match is determined by rank and years of service; for me personally the match amount would be 33.333%, based upon the average purchase price for the quarter. The employer match is made quarterly. To receive the employer matching contribution, you must be an active employee at the time the employer match is made.
Based on your post and previous comments this looks like a non-standard ESPP, and I was hoping you could help me to better understand it.
Harry Sit says
When can you sell the shares? Say you do 3% to start the 1-year clock. When can you sell the shares bought by this 3%? After one year, you bump it up to 15% to get the match. When can you sell the shares you bought and the shares from the employer match? If you can sell immediately after receiving the match, it’s a good program.
Jessica says
Hi Harry,
My ESPP plan is managed through Fidelity, and has no “lookback” provision (the purchase price is at the end of the purchase period). Typically, how would one set the account so that he/she can sell on the same day as the last day of the “purchase period” (to take advantage of the full 10% discount and avoid risk of falling price)? I called Fidelity; they said I’d have to wait at least 1 day after the last day, as it takes time for the purchase to reflect on the account or something to that effect. Thought I’d ask here if there’s another option to sell on the same day. Would appreciate any insight. Thanks!
Steve says
If there is a way to set that up, I never found it. In fact I often had to wait multiple days before I could sell. Try not to stress about it, the risk is generally low for just a few days.
Harry Sit says
The purchase price is calculated off the closing price of the last day. By the time the number of shares you purchased is calculated, the market is already closed. The soonest possible to make the shares available to sell would be the next business day. It’s normal to have a gap of a few days. Don’t sweat it. The market can go down in a few days in one period, and it can go up in another period.
Jessica says
Thank you very much!
EJ says
The problem with much of the analysis above is that it ignores the real wealth that is actually created over a period of time and that none of the created wealth is compounded / reinvested. No one is getting a 70+% annual ACTUAL return on their ESPP via a simple 15% discount (assuming same price stock) that happens 2 times a year; Not. Happening. The IRR and XIRR excel functions, while mathematically correct, are being misapplied — confusing real ROI, real wealth with a mathematically-correct function that can yield nonsensical, and grossly misleading information under certain circumstances.
The employee can’t go beyond a certain % salary to invest over a certain period of time (commonly 6 months, and commonly 10%). This is simply a LIMITED employee benefit — like discounted insurance. You have not discovered the best return on the planet…only a very good benefit that we should all max out, if we don’t mind tying up a percentage of our salary 6 months at a time, in return for being able to buy a limited amount of stock at 85% of market.
Here is a simple example to illustrate the flawed application of IRR / XIRR that yields zany, unusable numbers:
A coin dealer offers you 5% off (a discount) on the first coin you buy each year. The coin is $300 (market value), you buy it for $285. You’re happy. You sell it the very next day for $300 (market value), and make a quick, (1-day!) profit of $15. That’s an ROI of 5.26% — over a period of just one day — 1/365 of a year.
What happens if I plug in those cash flows and do an XIRR?
The annual “return” is laughably enormous… 13,517,116,720% You may have found the best return on the planet. Just. WOW. Time to shop for Teslas. And hedge funds, and unicorns.
But we know this can’t be real. Why? Because the algorithm took that very short 1-day return and annualized it over 365 days. The cash flow analysis, while technically correct — is useless. **It is the wrong tool for the job** and you get lousy, meaningless results disconnected from the real world.
*Remember, you can only buy the one coin, and only once a year.* The coin dealer created a scheme for you to come in and get the discount, but you aren’t getting rich on the return. You made $15. And you can do it once again next year. Sound familiar?
Note: IRR is all the rage in Private Equity these days, as it tends to inflate yield and frankly confuse investors. I’ll let you google it and find out for yourself the flaws….
Jess says
Hi Harry, thanks for this post. In light of recent Coronavirus pandemic, the stock price has at times dipped quickly by a large amount even within 1 day, and perhaps not unlikely to continue dropping in the coming days/months. The soonest possible to make ESPP shares available to sell are typically a few days (2-3 days, or next business day at best). In light of that, there’s less guarantee of receiving the discount when price continues to drop – what are your thoughts on contributing to ESPP during this time? Thanks.
Mike says
I know this an older article, but the calculator spreadsheet no longer appears to work. Is it possible to get it back?
Also, is it worth buying into an ESSP that requires a 2 year commitment before shares are purchased (and can then be sold)? Basically, I pay into the program over the course of 2 years, then at the end of the 2 years I get the shares at a 15% discount of whatever the lower price of the stock is either at the time the program started or the end of the 2 years.
Harry Sit says
The calculator still works but you don’t really need it. With a 2-year purchase period, your average holding time is about one year — your first payroll deduction is invested for two years and your last payroll deduction is invested for only a few days. For a one-year average holding time, you get a guaranteed 17% return (buy at 85, sell at 100). If there’s a one-year CD today that pays 17%, you’d jump on in a heartbeat. If the stock price goes up during the two years, the increase is added to your return.
Vadim says
One formula in the linked spreadsheet is incorrect. Cell C21 should be MIN(C13*(1-C12);C14*(1-C12))
James L says
Hi Harry,
Thanks for the great info! I have been participating in my company’s ESPP. My company has been acquired in a cash deal and now I got the cash at the acquisition price. Would this event be considered the same as if I had decided to sell the stocks that day and at that price for tax purposes?
Even if I had wanted to keep some of the stocks longer for preferential tax treatment, this event forces me to basically sell and lose out on any preferential tax treatment. Is there anything I can do in terms of the tax treatment for this “forced sell”?
Thanks so much!
Harry Sit says
Yes, getting paid cash for your shares is considered a sale. There’s nothing you can do about it.
Judy Hong says
Hi Harry,
Thank you for the great post! I love the linked spreadsheet for annualized return calculation. However, it provides for a 6-month offering period only. But my company is 7-month. Is it possible to adjust your formula to allow for a different offering period input than 6 months? I appreciate it!
Harry Sit says
The point is that the return is sufficiently high and it’s a no-brainer to participate to the maximum you’re allowed. Changing it from a 6-month offering period to a 7-month offering period changes the return numbers but it won’t change the conclusion. You should still participate to the maximum whether the annualized return is 50%, 70%, or 90%.
Judy Hong says
Thank you, Harry, for your prompt response. I stumbled upon your blog by chance, and I must say it’s been a truly hidden gem that I’ve thoroughly enjoyed following since then.
JB says
Question about the value of ESP discount if longer holding period before sale, thx.
– offering period & purchases both quarterly, priced @ 10% discount to avg of 30 days closing price before the offering period end
– BUT…shares bought then have a required *1 year hold* before can be sold.
– qualifying disposition if have held shares for over 2 years from beginning of offering period and over 1 year from date they were purchased (disqualifying if sold < 2yr from beginning of offering and <1yr from date purchased)
given this,
1) does the 1 year mandatory hold period negate the general 'guaranteed return' benefits described above? (maybe not worth it for just a 10% discount, given the 1 year lock-in?)
2) if one decides to participate but has to hold shares for 1 year before selling, does that now make it more worthwhile to continue to hold a further 12mo to be 'qualified' disposition or does the 'sell as soon as you are able' rationale still apply.