If your company offers employee stock purchase plans (ESPP), it is important to understand how they work and how to maximize your returns and minimize your tax liability. ESPPs are discounted shares of stocks offered to company employees through automatic investment.
Once you enroll in an ESPP, you must first state what percentage of your paycheck you wish to contribute towards the stock purchase. No stock is purchased at this point, only cash set aside is guaranteed for stock purchase at the end of the period. The maximum contribution is usually 10%. At the end of the period, as defined in your ESPP, the accumulated cash is automatically used to purchase company stock at a discount.
Discounts and accumulation periods differ by company. If you plan to maximize your gains, you should contribute the maximum amount allowed.
For example, if shares of your company are publicly traded at $10 per share (exercise price), and your ESPP offers a 15% discount, you will purchase them at $8.50 (grant price). If you decide to sell these shares immediately, as most employees do, then you have a guaranteed profit of 15%. This gain, however, will be taxed regular income, which is considerably higher than a long-term capital gain tax for stockholders who hold for over a year. In reality, your profit will be closer to 10% after taxes. Capital gains percentages are calculated based on your yearly income.
Suppose that you also have stock options and other stock in the company, and you feel that you are over-invested in the company. In fact, your entire portfolio may consist of your employer’s stock. In this case, it is best to sell right away and use the gains to purchase other investments in the open market. Another popular strategy is to sell right away, then take part of the proceeds of the sale to purchase company stock on the open market, while saving or investing the rest. You can use this option if the company’s stock unbalances your portfolio.
However, you don’t have to sell right away. If you know that your company has a hugely profitable product coming out, you can hold on to the stock and let it rise even more. However, employees who don’t have investing experience are often intimidated by this option and opt for the same-day sale with a guaranteed profit. Holding the stock can increase your profits as well as minimize taxes if you hold for over a year. If your company is clearly doing poorly, then it is best to sell right away. Note that if you are a high-level executive, the SEC may classify you as an insider, and your ability to trade shares granted by ESPPs may be handicapped.
If you decide to hold your shares, you can activate trailing stops at your brokerage to guarantee that you don’t incur a loss. For example, you now hold shares of your company with a purchase price of $8.50 which you can sell for $10 immediately. You can set a trailing stop at 15%, which guarantees that if the stock falls 15% at any given time, the stock will be sold immediately. This sell price will initially be set at $8.50, so in a worst-case scenario, you simply lose the bonus granted from the discounted shares and stop short of a loss. If the value of the stock rises to $15, the trailing stop will rise with it to $12.75. If the stock then falls to $12.75, it will be sold immediately. Trailing stops can be a powerful tool to protect your principal investment and guarantee gains, and if the share price stays above its stop price for over a year, you will also be eligible for lower tax rates.
Keep these considerations in mind when you enroll in ESPPs. Being well aware of your company’s financial health and utilizing these strategies will allow you to maximize your profits and minimize your taxes.