Equity compensation is becoming more and more popular as a form of compensation, especially for people who work for publicly traded companies. There are different types of equity compensation, such as restricted stock units, non-qualified stock options, or incentive stock options, but this article is going to focus on how to maximize an employee stock purchase plan (or ESPP).
An ESPP is a way for employees to participate in company stock and can purchase the stock at a discounted price. Money can be deferred from each paycheck (typically after taxes so there is no tax deduction) and is used to purchase company stock. This money that is deferred from paychecks sits in a “bucket” of cash and is usually used to purchase stock twice per year. There are a number of ways that it can be purchased at a discount, but the most common way is to have the ability to purchase the stock at a discounted rate once every 6 months (example is buying at 20% discount on the day of purchase).
A typical amount that is allowed to be deferred into an ESPP plan is 15% of your salary, and contributions are capped at $25k/year. If you are an owner in the company and own more than 5% of stock, you are generally not allowed to participate in these plans. There is no vesting period on this type of stock, and it can be sold immediately after being purchased if you chose to do so.
Since this is funded with after tax money, taxes are owed on any gain that is realized when selling the stock. This would be taxed at capital gains rates, which is your marginal tax rate if sold under a year (0-37%) and capital gains rates if held for more than a year (0-20%).
Here is an example of an employee making $250k/year participating in an ESPP plan:
Company stock is trading at $100/share and the plan allows purchase at a 10% discount. If this employee elected to fund 15% of their salary into the ESPP plan, they would hit the cap of $25k/year allowed (as 15% of 250k is $37,500 and over the cap). If they are paid twice per month, $1,041.67 is deferred into this plan each paycheck. If the stock is purchased every 6 months (July 1st and January 1st for example), then $12,500 has been deferred into the plan from January to July. On July 1st, 138 shares were purchased at $90/share, or whatever represents a 10% discount, with the $12,500 that is in the account. Assuming the stock is still worth $100/share for illustrative purposes, there would be an account value of $13,800, when it was purchased for $12,420. If the employee sold this immediately, they would have a capital gain of $1,380. Assuming they are in the 32% tax bracket, they would owe $441.60 in capital gains taxes, resulting in net gain of $938.40 on the stock.
Since we do not recommend having more than 10% of overall net worth in one single company, one strategy we use is to participate the max into an ESPP plan and then immediately sell the stock and reinvest into a diversified portfolio in a taxable investment account. This allows for the stock to be purchased at a discount, but also manages concentration risk of the investment by reinvesting into a diversified portfolio. Generally, people with ESPP plans also have other forms of equity compensation, so they have a large amount of money tied up in their company stock.
Another type of ESPP plan is the section 423 plan. These are qualified ESPP plans, meaning that no capital gains taxes would be owed on any stock sale, but taxes would be paid when the account is distributed in retirement. These are less common and can be more restrictive on when you can sell and access the money in the account.
Most equity compensation plans are specific to your company, so it is important to speak with a financial advisor to find the strategy that works best for your situation.
Equilibrium Wealth Advisors is a registered investment advisor. The contents of this article are for educational purposes only and do not represent investment advice.
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