The Adviser You Can Talk To Podcast
July 13, 2022
StockA financial instrument giving the holder a proportion of the ownership and earnings of a company. options can be a great wealth-building tool—but only if they’re used right. In this, our third episode to tackle the intricacies of maximizing your options, Andrew Busa and Michael Dillaire discuss employee stockA financial instrument giving the holder a proportion of the ownership and earnings of a company. purchase plans (ESPPs). Topics include:
Working out just how much employee stock options can benefit you isn’t easy. But it’s definitely worthwhile. Our experts can help you navigate this tricky process to your benefit. Listen now to learn more! Or check out our other episodes on stock option basics and restricted stocks.
The Godfather, Back to the Future and The Lord of the Rings—all three of these are famous trilogies. Join us as we complete our trilogy on equity compensation.
Hello, this is Andrew Busa, manager of financial planning at Adviser Investments. We are here with another The Adviser You Can Talk To Podcast. Today, I am once again joined by my colleague Mike Dillaire. He’s a CFP and a member of Adviser’s financial planning team.
Andrew, how are you?
I’m good. I’m good. You also have put in work, I know, on some equity compensation studies. That’s also going to be very useful for this episode, as this is part three of our series on equity compensation.
That’s right. We just got invited to the ESPPs. We’re going to talk about ESPPs, or employee stock purchase plans, the trilogy of equity compensation.
We love trilogies. We talk about movies all the time. This is going to try to top The Lord of the Rings, those greats. We’ll see what we can do.
This is our third episode on equity comp. We talked about ISOs and NSOs, incentive stock options, nonqualified stock options, last March, in 2021. We did an episode on restricted stock units, or RSUs, in August of 2021, and now employee stock purchase plans. We hope that these three episodes will cover most of what you need to know about equity compensation if this is something that you have as part of your financial plan.
Mike, take us through what we’ll be hitting today.
Sure. We’re going to talk about what you need to know about ESPPs and what makes them distinct, including a lookback period, which we’ll touch upon a few times today. What you need to know about how they’re taxed. We’re going to leave you with five ways to fully utilize ESPPs in your portfolio today.
Perfect. I think that will be a good structure. I do think, I guess anecdotally—and you can confirm this too—that maybe we’ve seen less employee stock purchase plans as time has gone on. I think RSUs and ISOs and NSOs seem to be more common, but we do still see these. It’s important to really think about how to best use them, how much to contribute, if you should contribute at all. Those are the things we’ll be talking about today.
Sometimes we’ll see a blend, too, of different types. It’s nice to have the trilogy of podcasts to take one by one.
Exactly. All right, let’s get into the basics. What do we need to know before moving on to the more complicated stuff?
ESPPs, again, employee stock purchase plans, are plans that allow employees to purchase their employer’s stock—I know, riveting name—through their payroll deferrals. There are a couple of key things to keep in mind for ESPPs. One, there’s a contribution limit of $25,000 worth of stock. That’s as of the grant date. You’ll hear the term grant date throughout the podcast as well, but again, it’s $25,000 worth of stock as of the grant date.
A company will have an enrollment period for their purchase plan, which is the duration of the ESPP when employees will sign on. The enrollment period holds one or more offering periods. For example, the enrollment period could be Jan. 1 through Dec. 31, but there could be multiple offering periods within the enrollment period. For instance, an offering period of Jan. 1 through June 30, and then a second offering period starting July 1 through Dec. 31. During these offering periods, that’s when the company starts to deduct the amount from your paycheck that you would defer.
Got it. As you go through that, I think this is obviously going to differ depending on your plan document. Important takeaway there is know what’s in your plan document. We can help with that, too, to help you decipher these different dates that you need to be aware of.
There can be many different offering periods within the enrollment period. It’s definitely good to review the plan agreement and documents prior. But at the end of the offering period, that’s when the purchase date happens. It’s kind of a confusing thing where they’re deferring money out of your paycheck, and then they’re not buying right away. They’re saving it for the purchase dates. That’s when the deferrals are, again, used to buy those company shares. It’s kind of similar to ISOs also, where it’s just for employees too. You want to keep that in mind.
Got it, just for employees. When you talk about the purchase happening at the end of the offering period, that could be where the lookback period that we’ll talk about in a second plays in, right?
We’ll circle back to that. I do want to underline another point that you said in there, that the contribution limit of $25,000—not a huge amount of money on an annual basis. Again, not insignificant, but it’s not like with certain RSU programs or ISOs where you could be accumulating a lot of money very quickly. Does that contribution limit get indexed up or what’s the story there historically?
It hasn’t moved much at all. It’s unlike 401(k)s or IRA limits that we’ve seen indexed with inflation, increasing $500 or so a year. The $25,000 limit hasn’t moved much.
I’m wondering why can’t you buy more? What’s the story there?
That’s where the good parts of employee stock purchase plans will come into play. They give you a discount typically. The good stuff with ESPPs is the companies allow you to sell their shares at up to a 15% discount on the fair market value of the shares. It’s like paying $85 for a crisp $100 bill.
I like that. That’s a big part of this, for sure. All right, you’ve got the discount. Let’s circle back to that lookback period and why that’s really powerful.
The lookback is great. It’s awesome to have that included in plans. Again, it’s not in all plans, but if you do have it, it is quite awesome because for people who are enrolled in those plans with a lookback, the purchase of the shares will not be based on the purchase date price. It will be based on the lower of the beginning price, aka the grant date, which I had mentioned earlier—it will be on the lower of the beginning price or the ending purchase date price, whichever is lower. Again, the grant date or the purchase date, whatever is lower, it will give you the discount from that.
Got it. As an example, if my company’s stock is $70 per share at the beginning of the offering period, but it’s $100 at the end, that 15% discount will be taken from the $70, which is a more favorable outcome for you.
Exactly. Back to the rule for ESPPs: There can’t be a greater than 15% discount. If there’s a lookback, it technically could be greater than 15% as of the purchase date, per your example. It would be the 15% off of that $70 instead of 15% off of the $100. It’s a powerful saving tool for employees. If your company offers a lookback period, it can be quite profitable for the employees.
That’s a really good point. We’ll talk about this in the five ways to maximize toward the end of the episode. But I think generally, we have said: Look, if you’ve got a combination of at least a 10% discount and a lookback period, you should enroll in one of these things, most likely, but we’ll talk about that more.
That’s a really good overview of the basics—I feel like not too complicated. What could be more complicated are taxes, unfortunately. Never straightforward, but we’ll try to clear some things up here. Just generally, how are shares purchased through an ESPP taxed?
Well, much like a 2007 Facebook status, it’s complicated.
Oh, I miss those days.
For starters, there is no taxation at all when the purchase is made, which is really nice. Also, ESPPs don’t incur a FICA tax, which is what sets them apart from NSOs and RSUs, which again, we’ve covered in previous episodes. The taxes that you pay are dependent on when you sell. Similar to buying a stock, you aren’t taxed when you buy, only when you sell. To that point too, much like ISOs, there are qualifying and disqualifying dispositions for your ESPP shares that could be taxed at long-term capital gains rates.
Got it. We’ll cover what we mean by qualifying and disqualifying dispositions here in a second. But just to review that too, FICA tax, that’s going to be Social Security and Medicare tax on your earnings. Again, that sets ESPPs apart from ISOs and NSOs. But we’ve talked about qualifying and disqualifying dispositions in our past equity comp episodes. Let’s review what we’re talking about high level here as it relates to ESPPs.
Again, it’s similar to the ISOs, and the ISO rule was two years from grant, one year from exercise. But with ESPPs, it’s two years from enrollment date and one year from the purchase date. If you wait and sell the shares in a qualifying disposition, the difference between the discounted price and the fair market value at the end of the purchase period will always be taxed at ordinary income rates. We can’t get long-term capital gains there, but the growth of the stock from the fair market value is taxed at capital gains rates—again, in a qualifying disposition.
Thinking back to the example before where there was the $70 versus $100: You would buy it with the lookback period—you would’ve bought it at $60, 15% off of $70, but the stock was trading at $100. Anything above the $100 when you sell is the long-term capital gains rates, but that $40 difference, that’s the ordinary income tax. Again, it’s quite complicated.
I mean, I think it’s complicated, but that’s a good way of, I think, summing it up: With a qualifying disposition, you’re going to be dealing with a combination of ordinary income tax and long-term capital gains rates. Again, long-term capital gains rates are going to be more advantageous. It’s going to be a lower rate compared to your ordinary income tax bracket. That’s why qualifying dispositions, if you can achieve that, is a good thing, which leads us into talking about disqualifying dispositions, which is a little bit simpler, right?
Yeah, it’s less complicated. It’s basically all just ordinary income, but remember there’s no FICA tax. You do get to keep about 7.65% more from your ESPP proceeds.
Got it. I mean, I think that covers most of what someone would need to know about qualifying and disqualifying dispositions. Know your dates, know when you purchased, how long you’ve held the stock. I think the key here is just don’t be surprised when you go to sell some of your stock in terms of how it’s going to be treated tax-wise. Consult your tax adviser, your financial planner, to make sure that you know what’s about to happen tax-wise. Good recap of taxes. Before we leave this topic and move on to five ways to maximize, anything else to touch on that makes ESPPs distinct from restricted stock or stock options?
Yeah, ESPPs are primarily at public companies. The reason being it’s really hard to gauge a valuation of a private company to track the growth of the stock. The majority of the time, we see ESPPs at public companies. There’s also no 83(b) election, which we’ve talked about for usually RSUs in other episodes. There’s no 83(b) election. There’s also no AMT. There’s no alternative minimum tax, which is what we would see with ISOs.
Thank God, because then we would’ve had to talk about AMT.
Yes, I don’t want to talk about AMT.
Which probably no one wants to hear about, but maybe we’ll do an episode on that someday. All right, let’s get into our lightning round here of five ways to maximize your ESPP shares. You lead off. You take the first one here.
Numero uno, I’ll go with look at what your company is offering. Due to changes in tax and accounting law from 2007 onward, ESPPs became much less favorable for companies financially. Again, that’s why we had mentioned prior to the beginning of the episode that we have seen the ESPPs less and less lately and more of an either balanced approach or just strictly other stock options. Again, it makes ESPPs less attractive to employees because of the added costs for companies. Typically, they’ll reduce their discount or even remove the lookback feature. A good rule of thumb is 10% or more on the discount and a lookback provision is a good minimum to participating. But again, whatever the plan agreements, if we read that, we’ll give you recommendations from there.
Got it. That’s a good rule of thumb on the participation threshold. I’m going to lead into number two here. Let’s say you’ve decided to participate, well, number two is decide how much you’re actually going to contribute.
As you mentioned, Mike, if you have that lookback period and that discount percentage, you should enroll, for the most part. You’re going to be locking in a profit, hopefully. But when we think about how much makes sense to actually contribute on a going-forward basis for that, you’re going to want to assess your balance sheet. Do you have an emergency fund? Are you contributing at least to get your match on your 401(k)? Are you saving toward other short-term goals and really thinking about how tight your cash flow is on a monthly basis? If you’ve got extra money beyond those other goals that you’re saving for, this could be a great place to put this extra cash flow that you don’t really know what to do with to, again, maybe save for certain goals faster while taking advantage of that discount percentage. It’s going to vary depending on individual plans.
Exactly. That’s why it’s always good to read the plan prior.
Yeah, for sure. I’m going to lead right into number three: Participate in early-stage growth. You mentioned, Mike, ESPP is often offered for public companies. If you’re at a very young public company, this can be a great way—and a tax-efficient way—to participate in the growth of that company at a discount. Of course, we would be remiss not to mention that shares of stock can fall in value too. No stock is guaranteed to go up forever, which leads into your point on number four.
Number four, we’re going to go with avoid concentration. ESPPs are not often the only form of equity compensation our client is receiving. I know we touched upon it a couple times, but they might also be receiving stock options and RSUs. If so, ESPPs might exacerbate your concentration of your company and probably should be avoided. 10% of your net worth is a great target to have for a specific stock. Depending obviously on people’s situation, it could be a little bit more, a little bit less, but that’s usually our rule of thumb is 10% of your net worth.
But one caveat here—and a reason to possibly hold your shares or more than 10%—is if you have an ownership requirement. Some companies will require that you maintain a certain number of shares. In these cases, ESPPs might be an easy way to clear that bar without having to exercise options when you don’t want to. Also, ISOs, NSOs and restricted stock—ESPPs are more like the garnish because you’re limited to that $25,000 annually. Think of it like a garnish to the meal instead of the entire meal.
I’m getting hungry. Wrap us up with our final point here.
Sure. Going back to the qualifying versus disqualifying disposition, don’t let the lure of a qualifying disposition take you off your path. Going along with what you spoke about, you run a risk when you hold your ESPPs for the full period, especially if the stock is volatile. Obviously, this is dependent on each individual specific situation, but the recommendation may not always be to buy and hold the shares. Yes, taking advantage of growth is awesome, but sometimes selling the shares immediately after the purchase is a great way to diversify those now liquid assets. You’d lock in that profit of the discount they give you. Then you’re able to diversify those funds. It would lead to a disqualifying disposition. However, you would just be charged ordinary income tax. Yes, potentially more taxes, but definitely better to diversify, especially if your portfolio is heavily concentrated. Don’t let the tax tail wag the dog.
I was about to say the same phrase. We all should strive to be as tax-efficient as possible but not at the expense of making not-ideal financial planning decisions for your overall plan. Ultimately, paying taxes does mean that you made money. It’s not a pleasant thing to do but something that, like you said, don’t let that qualifying disposition outweigh a good decision otherwise.
I think it’s time for key takeaways, as is tradition, to wrap up the episode.
I’m going to go with something I just spoke about too, but my key takeaway was they are a great way to save. ESPP is a great way to save, but know what you’re being offered, make sure it’s a good deal, and avoid concentration.
Those are good ones. I’ll come back to something we said a couple of times, but again, if you’re getting at least that 10% discount, if you have a lookback provision, that is usually a green light to, at the very least, start participating in your ESPP. Then from there, it’s a question of how much to contribute, which will depend on your individual situation. We can help you with that as we assess your entire financial plan.
Well, good. This has been Andrew Busa and Mike Dillaire from Adviser Investments thanking you for listening to The Adviser You Can Talk To Podcast. If you enjoyed this conversation, please subscribe and review our show. You can also check us out at www.adviserinvestments.com/podcasts. Your feedback is always welcome. If you have questions or topics that you’d like us to explore, please email us at firstname.lastname@example.org. Thanks for listening.
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If you have at least a 10% discount and a lookback period, you should enroll in an [employee stock purchase plan].
If you have at least a 10% discount and a lookback period, you should enroll in an [employee stock purchase plan].
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