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One old school investment strategy is to “Buy What You Know”—in other words, invest in the companies and brands you're familiar with and that you believe in. Investing in the company you work for and believe in can be part of a solid equity allocation. This can especially be the case if your company has an Employee Stock Purchase Plan (ESPP).
This type of plan allows you to buy shares of company stock at a 5-15 percent discount of the stock's market price using after-tax dollars. There can be other advantages included in certain plans, such as a lookback, that can let employees get an even better deal. We break down what you need to know before adding company stock to your investment plan.
A Breakdown of the ESPP Cycle
Enrollment/Offering Date
An ESPP is a benefit extended at some publicly traded companies that grants employees the ability to buy their employer’s stock at a discount. Employees can typically enroll in their employer's plan twice a year and choose the percentage of salary to contribute, typically up to 15 percent of annual salary or $25,000.
Once enrolled, the company will set up your personal ESPP account, often with a brokerage company like Computershare. From there, they transfer funds directly from your paycheck into the account to buy shares. The program enables employees to sign up for a 12-month offering period, which is the official start of most plans' ESPP participation. This is also the beginning date for tax purposes, as well as the date at which they set the price for the lookback benefit.
Enrollment Period/Purchase Period
During this time, payroll deductions are set aside, and you begin accumulating funds within the plan. This typically lasts for a year, from which shares are purchased twice a year using the funds in your account. The company buys the stock on your behalf at a below-market price, typically a 15 percent discount. Plans that adhere to the rules under Section 423 of the IRS tax code specify that the employee’s discount on stock purchases is capped at 15% below the market price.
Some ESPPs include an extra benefit called the lookback period. With this feature, the employee still obtains a 15 percent discount, but it is applied to the lower of two prices — the stock price on the first day you began to set aside money or the stock price on the day of the purchase.
Here’s how the look back works, using as an example a company that has a 15 percent discount and a six-month lookback:
On the employee's offering date of June 1, the stock was trading at $15 a share. By the purchase date of December 1, it had climbed to $20 per share. The look back means you can purchase a stock trading at $20 for $12.75 (a 15 percent discount on the June 1 price of $15).
The purchase date is the end of the payroll deduction period and when shares are bought. Some offering periods include several purchase dates when stock may be bought.
The Transfer Phase
The employer is responsible for safeguarding employee funds that are accumulating in the plan. The company then buys shares of the company's stock twice a year. The mechanics of this process is that the brokerage administering the ESPP plan makes the actual equity purchases. The brokerage then transfers ownership of the stocks to the employees enrolled in the plans. Any cash that is leftover from the purchases is refunded to the employee.
The brokerage that is administering the ESPP will also mail a trade confirmation to the employee. Employees do not receive a tax bill when the shares are purchased on their behalf and transferred to them. But there are tax obligations when you sell the shares.
Different Plans, Different Taxation
The most common ESPPs are qualified, which is different from a qualified retirement plan. Other types of ESPPs are non-qualified or direct purchase plans. With tax-qualified or qualified ESPPs (adhering to IRS Section 423), the employee obtains favorable tax treatment for the purchase discount if they own the shares for enough time. The optimum waiting period is more than two years from enrollment in the plan and at least one year from purchasing the shares.
After waiting the requisite time before selling, the discount on the purchase price and the remainder of the profit will be taxed at the long-term capital gains tax rate. If you sell the shares immediately after the units are purchased on your behalf, you will pay ordinary income tax on the discount you receive on each share (the IRS considers the discount to be salary).
Non-qualified plans may offer discounts higher than 15 percent on each share and provide matching shares. However, they lack the tax advantages. With non-qualified plans, employees receive a tax bill when the shares are purchased on their behalf (you pay ordinary income taxes on the discount you received at the time of purchase).
Thinking it Through: What to Consider
Risk from Investment Losses
Just as with any individual equity, the value of the stock in your ESPP can fall for a variety of reasons, including company bankruptcy, inflation, a recession or other economic slowdown. A 15 percent drop in the value of your shares can eliminate the value earned by participating in the plan. The risk of losing money is even more critical when your income and a substantial portion of your investment portfolio depend on one company's performance.
In addition, some employees at firms with an ESPP may also receive stock options and restricted stock as part of their total compensation. If the company is enjoying robust performance, these employees may end up owning a substantial percentage of company stock relative to their total holdings.
Risk from Over-concentration in Company Stock
ESPPs are a much different animal than other plans that companies use to offer employee stock ownership. ESPP enables employees to invest in company stock at a significant discount, but it’s important to monitor your account to prevent your holdings from becoming too a large percentage of your investment portfolio.
When your overall investment portfolio has a large percentage held in company stock, you may not have enough diversification. As my industry's regulatory authority FINRA states in their Investor Insights article on the topic, when you invest in your own company, your finances are doubly exposed.
What's this mean? In the event your company falters, not only might your investments tumble, but you might also find yourself out of work at the same time. Just ask former employees of Enron, Lehman Brothers, and Radio Shack, who watched shares in their company plummet while being shown the door.
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This is for informational purposes only, is not a solicitation, and should not be considered investment, legal or tax advice. The information in this report has been drawn from sources believed to be reliable, but its accuracy is not guaranteed, and is subject to change. Investors seeking more information should contact their financial advisor.
References to any company, securities, investable product, exchange, or technology are for illustrative purposes only, and not an endorsement or recommendation to buy or sell any investment, product, or service.
Investing involves risk, including the possible loss of principal. Past performance does not guarantee future results.
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