How Do Employee Stock Purchase Plans Work

How Do Employee Stock Purchase Plans (ESPP) Work?

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Do you have access to an Employee Stock Purchase Plan (ESPP) at work but are unsure if it’s a good investment? If you want to fully understand and maximize your employee stock purchase plan, we have put together fourteen tips to help you get there!

What is an employee stock purchase plan?

An employee stock purchase plan (ESPP) is a benefit offered by several large companies such as Hilton, Disney or Apple. It allows you, as an employee, to buy company stock at a discounted price. The discount is often up to 15%.

You can usually purchase ESPP plan stock worth 1% to 15% of your salary, up to the $25,000 IRS limit per calendar year.

If you participate, your employer will deduct your contribution directly from your paycheck. Your employer will then purchase the company stock for you, typically at the end of a 6-month period.

You will usually get an email from Human Resources twice a year, asking if you’d like to participate and whether you’d like to change your contribution amount. 

What are the benefits of an employee stock purchase plan?

An employee stock purchase plan allows you to buy company stock at a bargain price. Discounts usually range from 5% to 15%.

For example, if you work and participate in Hilton’s ESPP, you can buy Hilton stock at a 15% discount. If Hilton’s stock is trading at $130/share, they’ll buy it at $110.50/share for you. If you decide to sell it immediately, you get a profit – the difference between your purchase price and the trading or selling price. In this scenario, if you decided to buy $20,000 worth of Hilton stock via their employee stock purchase plan program, with a 15% discount, you would have made a $3,000 profit. 

It’s like free money if you play it right.

It gets even better. Most ESPP plans have a lookback provision. This allows you to buy the stock either at the purchase date price or the price when the ESPP plan was offered, whichever is lower. So using the above example, if Hilton’s stock price was $110/share when the ESPP plan was offered to you, the discount can be applied to the $110/share instead of $130/share (trading price), which significantly increases your discount!

Do you pay taxes on an employee stock purchase plan?

No taxes are due when you buy the company stock under an employee stock purchase plan. When you sell the stock, you pay either ordinary income or capital gains tax on the gain, and you pay ordinary income tax on the discount. 

If you sell the stock immediately after it was purchased, you will have to pay ordinary income taxes on your gain/profit, based on your federal income tax bracket. If your tax bracket is 24%, then you have to pay 24% taxes on your profit. Your profit is the difference between the price you sold the stock for, and the price you bought it for.

In our above example, if you bought 100 shares of Hilton stock via its ESPP plan at $110/share ($11,000 cost), and sold it immediately for $130/share ($13,000 value), then your profit is $2,000. If you’re in the 24% tax bracket, you owe Uncle Sam $480.

If you live in a state with state income taxes, then you also have to pay state income taxes on that profit.

If you sell the stock after holding it for at least one year, the taxation of employee stock purchase plans gets favorable but complicated. Instead of paying the ordinary income tax rate, you pay the lower long-term capital gains rate, which is 15% for most Americans. You also need to sell it at least two years after the ESPP offering period began to get this favorable tax treatment (remember that Human Resources email). 

Using our above example, let’s say:

Employee Stock Purchase Plan

What are your taxes on this employee stock purchase plan example?

  • Ordinary income taxes: 
    • With an ESPP, you pay ordinary income taxes on the discount portion of the purchase. 
    • Compute the difference between: Either Hilton stock price at offering ($130/share) or when they purchased it for you ($140/share), whichever is lower ($130/share); and the price you bought it ($110.5): $19.50/share discount. 
    • If you bought 100 shares, then your “ordinary income profit” is $1,950.
    • If you’re in the 24% federal income tax bracket, then your ordinary income taxes on this sale is $468.
  • Capital gains taxes:
    • Remember that most ESPP plans have a lookback provision, which allows you to buy the stock either at purchase date price or the price when the ESPP plan was offered. In our example, the offering price ($130/share) is lower than the trading price ($140/share), so the discount will be applied at the offering price. 
    • Compute the difference between the price you sold it for ($170/share) and the offering price ($130/share): $40/share profit.
    • Since you bought 100 shares, your “capital gains profit” is $4,000.
    • If your capital gains tax rate is 15%, then your capital gains taxes on this sale is $600.
  • Total taxes due on this employee stock purchase trade: $468 of ordinary income taxes and $600 of capital gains taxes = $1,068.
  • If you did not hold the stock for at least a year after selling it, your total taxes (all ordinary income taxes) would be $1,428 ($170/share less $110.5/share ($59.50/share) times 100 shares times 24% tax rate).
  • You saved about 25% in taxes in a qualified sale. ESPP long-term capital gains make a difference.

If you sold the stock for a loss, you can declare that capital loss in Schedule D.

Social Security and Medicare taxes do not apply to ESPP plans.

In summary, are employee stock purchase plans taxable? After you sell the stock, yes. You’ll have to pay ordinary income tax and capital gains tax on the price gain, depending on how long you held it, plus ordinary income taxes on the discount. 

👉 Curious if you will have to pay tax on your ESPP? Find out here!

Is ESPP reported on W2?

In the year you sell your ESPP shares, your employer may report your “ordinary income profit” on your W-2. This is equivalent to your purchase price discount. 

You have to look closely at your W2. If your “ordinary income profit” was not reported, you still will have to report that on your 1040 as “other income.”

How do I report ESPP on my tax return?

If you owe ordinary income taxes, report the amount on your 1040 as “other income.” If you owe capital gains taxes, fill out Schedule D and Form 8949.

Remember: Your employer does not withhold taxes related to your ESPP stock plan sales. So you will have to report any income yourself on your tax return.

Do not report the discount on your tax return unless you’ve sold the ESPP plan stock. 

Can I cash out my ESPP?

You can sell your ESPP plan stock anytime. Your ESPP stock is a liquid investment, which is one of the benefits of an employee stock purchase plan. You just have to be aware of the tax implications when you cash out your ESPP.

What happens to my ESPP when I quit my job?

Once you buy the company stock via your ESPP plan, that’s yours. Quitting your job doesn’t change anything. If you work in Apple, get Apple stock via Apple’s ESPP plan, then move to Disney, you can either keep your Apple stock or sell it.


How long should you hold ESPP? Should you sell your ESPP right away?

If you’d like to make a riskless profit from your discounted purchase, you can sell the company stock immediately after purchasing. If you’re getting a 10% discount, then you can generate a riskless 10% profit from your employee stock purchase plan. This is one of the best benefits of an employee stock purchase plan.

If you’d like to pay lower taxes, you can choose to hold the company stock for at least a year after buying it and two years after the ESPP offering date. If the ESPP plan stock goes up by 20% after you purchased it, then your profit would be the discount (say 10%) plus the price gain (20%, in this example).

Can you lose money on ESPP?

You can lose money on your ESPP plan if you don’t sell the company stock immediately and the price goes down. If you purchased the stock at a 10% discount and the stock price declined by 15%, then you would have lost money. Stocks, especially tech company stocks, are highly volatile. So you have to have the stomach to tolerate wild fluctuations in prices.

 

What are the pitfalls of an ESPP plan?

The worst-case scenario in an ESPP plan is this:

  1. You participate and buy significant amounts of stock each year (say $20,000 each year for 20 years, totaling $400,000 in “capital”);
  2. You then hold it for a long period of time;
  3. Your ESPP plan stock is now worth several hundred thousand dollars, which may represent a significant portion of your wealth or retirement savings; 
  4. Your company’s stock price plunges, and you lose significant money.

It is really risky to hold huge amounts of money in one ESPP plan stock. Stock prices can go down due to a whole host of reasons. New government regulations can significantly impede the company’s business. A competitor can make a better product, and the demand for the company’s product declines. There could be an accounting scandal. Or a new technology disrupts the entire industry.

 

How much should I put in an employee stock purchase plan?

You can contribute 1% to 15% of your salary, up to the $25,000 IRS limit per calendar year. The more disposable income you have, the more you can afford to put in an employee stock purchase plan. Employees contribute through payroll deductions. For example, if your paycheck is $4,000, and you elect to contribute 10% of your pay to your ESPP, $40 will be deducted from your paycheck each pay period. 

While contributions to a 401(k) or an IRA is not so liquid (early withdrawal penalties may apply), this is not the case for how employee stock purchase plans work. Once you contribute and purchase the ESPP plan stock, you can always sell without any penalties. Since companies often purchase the stock for you every six months, your contribution is liquid after that time period.

Since you are investing in a highly volatile investment (an individual stock), you also need to factor in your risk tolerance. Ask yourself, what might be your reaction when your employee stock purchase program stock goes down by 20%? Do you usually remain steadfast during stock market downturns, or do you tend to panic and sell your stock holdings? The higher your risk tolerance, the more you’re able to participate in an employee stock purchase plan.

 

What is an ESPP qualifying disposition?

An ESPP qualifying disposition is the sale, transfer, or exchange of shares acquired through an ESPP that meets specific requirements. These requirements are that the ESPP is sold or disposed of more than two years after the start of the offering period and more than one year after the shares were purchased under the plan.

When these requirements are met, the gains from the sale of ESPP shares in a qualifying deposition are generally taxed at the lower long-term capital gains tax rate instead of the higher ordinary income tax rate. This can result in significant tax savings.

 

Is ESPP qualified or non-qualified?

An ESPP can be either qualified or non-qualified. It depends on whether they meet certain requirements under the tax code.

A qualified ESPP plan is one that meets the criteria in Section 423 of the Internal Revenue Code. Under this plan, the employee may be eligible for preferential tax treatment. To qualify, the ESPP must be a written plan approved by shareholders and meet some other requirements. 

  1. It must be available to all employees of the company or a designated group of employees.
  2. The stock purchase price discount cannot exceed 15%. 
  3. The offering period cannot exceed 27 months.
  4. The employee cannot purchase more than $25,000 worth of stock in a calendar year.

A non-qualified ESPP plan is one that doesn’t meet the criteria in Section 423 of the Internal Revenue Code. Despite being more flexible, these plans do not qualify for preferential tax treatment.

ESPP: Qualified vs Non-Qualified Plans

Qualified ESPPNon-Qualified ESPP
ContributionsMade after-tax dollarsMade with after-tax dollars
Does it operate according to Internal Revenue Section (IRS) 423 regulations?YesNo
DiscountDiscount ranges from 0% to 15%May offer a discount of more than 15% from the current FMV of the stock
Who approves it?Approved by shareholdersNot required
TaxationMore favorable on taxation. There is no taxable event when shares are purchased.Less favorable on taxation, e.g. ordinary income is taxable at purchase
FlexibilityLess flexibleMore flexible

Are employee stock purchase plans a good idea in 2024?

Once you fully grasp how employee stock purchase plans work, participating in your company’s ESPP plan can greatly maximize your employee benefits. You can purchase company stock at a discounted price. You can sell your ESPP plan stock immediately to lock in your profit from the discount. You pay lower taxes if you hold the company stock for at least a year and sell it for more than two years after the offering date.

However, there are risks to participating in an employee stock purchase program. There is a chance of making errors in tax reporting, given the complexity of taxation of employee stock purchase plans. The ESPP plan stock price can go down significantly once it is bought for you. It is best to consult a credentialed financial advisor who has the knowledge and experience on how employee stock purchase plans work.

Best Financial Planner Washington DC

Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.

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District Capital is an independent, fee-only financial planning firm. We help professionals and entrepreneurs in their 30s and 40s elevate their finances and maximize their money. We are based in Washington, D.C and we work with people virtually nationwide.

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