In our latest episode of ThimbleberryU, Jag and I continue our six-part series focused on the tech sector. We delve into Employee Stock Purchase Plans (ESPPs), a topic particularly relevant to our tech professional listeners. An ESPP is a program allowing employees of public companies to buy company stock at a discounted price, typically through payroll deductions. We emphasize the importance of the discount, noting that not all ESPPs offer this benefit.
We compare ESPPs to 401k plans, highlighting the immediate financial gain from the discounts, which can be as high as 15%. We explain the typical structure of these plans, including offering periods and the mechanics of purchasing shares at a discounted rate. The specifics of these plans, such as the discount rate and the timing of stock purchases, are set by the employer.
Next. we cover the tax implications of ESPPs. While the discount is taxed as ordinary income, the real tax benefit comes when selling the shares. To maximize this benefit, shares should be held for at least one year after purchase and two years from the start of the offering period. This strategy allows gains to qualify as long-term capital gains, which are taxed at a lower rate than ordinary income.
We also explore strategies for making the most of ESPP participation. We advise contributing the maximum amount allowed and discuss the importance of selling shares strategically. We note the risk of stock volatility and the potential issue of being too financially tied to one's employer.
We share a real-life example of a client, who successfully used his ESPP to fund his children's college education and boost his retirement savings. This illustrates the power of ESPPs as a tool for achieving various financial goals.
Finally, we discuss aligning ESPP participation with broader financial objectives. We stress the importance of understanding one's financial goals and how ESPPs can play a role in achieving them. You should consider your overall financial position and level of investment in your employer's stock when deciding whether to sell or hold ESPP shares.
Jon Jag Gay: Welcome back to ThimbleberryU. I am Jon Jag Gay, joined as always by Amy Walls from Thimbleberry Financial. Amy, great to be with you.
Amy Walls: Jag, it's great to be with you.
Jag: Today is part two of our six-part series dealing specifically with those in the tech sector. I know this is a real area of specialty for you at Thimbleberry. We're talking about those ESPPs today, those employee stock purchase plans. We've talked about them in previous episodes. We're going to dive a little bit deeper than we have previously today. Where do we start?
Amy: Let's talk about what ESPP is, first of all. As you mentioned, it is an employee stock purchase plan. It is a fantastic benefit that many of our tech professionals have access to. Now, this is going to be through a public company. Basically what it does is it allows the employee to purchase company stock at a discounted price, typically through payroll deductions. At least that's how the best ones work. We have seen some ESPP plans where it's just an opportunity to buy stock, no discount. That's really not what we're talking about today. We're talking about the nice ones with a great discount.
Jag: Glad you made that point of differentiation. Go ahead.
Amy: The beauty of an employee stock purchase plan lies in its simplicity. As I mentioned, they offer the opportunity to become a shareholder in the company that you work for. The best ones have a 15% discount on your share price, which creates an immediate gain.
Jag: That makes sense. Okay.
Amy: It's a little like contributing to a 401k with an employer match.
Jag: Yes, exactly what I was just thinking. The benefit is immediate.
Amy: Exactly. As long as you do certain things.
Jag: [laughs] There it is.
Amy: Like we just said, that discount, huge advantage. Employee stock purchase plans also often have offering periods lasting a few months. When you subscribe, you may be in it for six months, for example. Some are longer. Most often I see six months. At the end of that six months, your contributions that you put in along the way are used to purchase the shares at that discounted price. Every ESPP can be framed a little bit different. When it buys those shares, it may be at a discount from the end of that period. They may buy from a discount at the beginning of the period. I've even seen, and this is the Cadillac of plans, is a discount, again, ideally 15%, on the lowest price in the six months.
Jag: You answered my next question about how it works, but I think it's important to underscore this, Amy, that it's payroll deducted for a set period, and then the purchase happens at the end of that period based on whatever criteria you just walked us through.
Amy: Correct. That's the employer sets those criteria, not the employee.
Jag: Yes, that much I was able to deduce on my own, but thank you for making sure we're all on the same page here. Of course, they sound appealing, Amy, these ESPPs, but what about tax implications? How can tech employees optimize the tax advantages of the ESPPs?
Amy: The discount that someone receives when purchasing the shares is typically taxed as ordinary income, but the real tax benefit can come in when you sell the shares. To minimize taxes, if that's the goal, the best thing to do with an ESPP is to hold the shares for at least one year from the purchase date and two years from the beginning of the offering period. When you do that, that gain can qualify really as long-term capital gains, which then have a lower tax rate than ordinary income.
Jag: Or short-term capital gains, which would be hit at that rate if you didn't keep it very long.
Amy: Correct.
Jag: Okay, let's zoom out from the taxes, Amy, and turn to specific strategies that tech folks can employ to make the most of their ESPP participation.
Amy: The first strategy I'd say is to participate at the maximum amount you're allowed to participate. This could be set by your employer, but they are also capped by the IRS. The most anybody can contribute in a year is $25,000, and that is not indexed for inflation. Your employer may say, "Oh, you can contribute 10% of income or 15% of income," but if that 10% or 15% is above $25,000 over the course of a year, they're going to cut you off early. Other strategies, it goes back to the taxes we just talked about. That's the best way, as I mentioned, holding the shares to get long-term capital gains and take advantage of the taxes.
When we talk about strategies, it's considering how to sell the shares strategically. We could hold them for a long time, but one of the things we talked about right up front is the benefit of these ESPP shares is the discount. If we are holding them for a period of time, the issue might become that the stock is volatile, that the employee also works for the company, and, therefore, is tied to the company in a way outside of stockholding.
Jag: You're too concentrated at that point because your wages are coming from a certain company and your investments are tied to the performance of that same company. That can be dangerous in certain situations.
Amy: Absolutely. From a strategy perspective, just like contributing the amount you need to your 401k, even if the 401k isn't the best investment vehicle for you contributing so you get the match, it may be best to just participate to get the discount. Turn around and sell once the shares become available rather than waiting and holding them for the preferential tax rate.
Jag: That's a really good point, Amy, and I want to make sure that I'm following, so if I can follow, then for sure [chuckles] our listeners can follow. The idea being here, you're purchasing that stock at a 15% discount. If you hold it long enough for it to be on the long-term gains taxable rate and the stock price is the same, again, if the stock price is the same as when you purchased it. If you turned around and sold it, you've essentially made a 15% profit because you saved 15% when you purchased it. That's something to consider in certain situations. Do I have that right?
Amy: That's correct.
Jag: Let's put some tangible stuff to this. Can you give us some real-life examples, obviously not mentioning names, but of tech executives and employees who have efficiently used ESPPs to their advantage?
Amy: Absolutely, Jag. One client that comes to mind who's benefited greatly from the ESPP, let's call him Sam, diligently participated in his company's ESPP plan. He had one of these great plans, they did a six-month window, got a 15% discount over the lowest price in the six months. Over the years of working for that company and participating, he accumulated, at a sizable discount, a significant number of shares. They added up over time. What he did is he did sell strategically along the way, wanting to take advantage of the free money that the plan offered him. He diversified and used those funds to fund children's college education and boost his retirement savings.
He used it as something you said earlier. It's an automatic payroll deduction. He used it to force savings on a per-paycheck basis that he turned around and used after realizing them at a discount to put into his specific goals.
Jag: This is perfect because it gets that 15% back that you talked about, but then also, you're turning around, taking that profit and reinvesting it. So you're staying diversified and avoid being too concentrated in the company. It really checks all the boxes we've talked about so far in this one particular example.
Amy: Absolutely. It's a really powerful tool. I think where a lot of times people get caught up is in the heap of expenses, all of a sudden adding in a $25,000 bill each year, for example. People flinch for a moment and say, "All of a sudden I'm going to start doing this?" When you think about it, it's “forced savings,” which often allows you to save more and save better, save more consistently. It's a win, especially with that discount.
Jag: For sure. We're touching on our next topic already, Amy, but how can tech employees ensure that their ESPP participation aligns with their broader financial objectives?
Amy: First, we have to know our objectives.
Jag: Yes, that's fair.
Amy: It's really easy to say, "Hey, I'm doing this thing," but not know why we're doing it. I think in our busy lives, we do that more and more often. What is it financially I'm trying to achieve? That's the first question. Then does this tool play a role and how can it play a role? Through that automatic savings, as long as you can be diligent about diversifying and have a strategy to do so on a regular basis, it can really fund all sorts of goals. I've seen it fund a simple cash reserve. Somebody had a life event and had spent down their cash reserves and we used their ESPP to force that. Then when it did come due, they just used it to replenish cash along with their regular savings.
Like I mentioned, we've had it be used for college education. It's a really nice, simple way to get that college funding going consistently and then supplemental retirement income outside of other retirement savings that's happening. It's really incredibly versatile. It's about what's the right strategy for you and how to then execute on that systematically.
Jag: It makes a lot of sense and there certainly are a lot of benefits to this. What should people, before we wrap up, Amy, consider when deciding whether to sell or hold those ESPP shares?
Amy: I think we go back to what I said at the beginning of the last topic, it's purpose. What are you trying to achieve by participating? Is it free money in the form of the discount? An expectation of the stock price increasing, meaning you're speculative and believe that the company stock is going to go up? I think another piece to add in there is that you're also in a financial position that if the stock price goes down and knowing that you work there, you're not going to be hurt financially. Or is it something else? Depending on the answers to that, I think it really drives, am I going to sell or am I going to hold?
Underlying that, which I alluded to, is what other assets do you have? If you're in a financial position, if you're financially independent and you say, "Hey, I'm willing to be speculative on my company stock while I work here because I don't even need to work anymore," then we know you have enough other assets to support you going forward and this is more fun money at that point.
Jag: Yes, for sure.
Amy: I think another question is how much do you own in other company stock? Meaning not other companies, but of your employer that you're sitting on? How bad or how good is your concentration? One question I think is a really powerful question to ask is, and it's not going to be powerful now because we've just talked about all of these things, but a question I like to ask out of the blue is, "You're considering buying the stock and you're trying to figure out if you should hold it or not. Right now, would you be willing to take part of the money that lands in your bank account from each paycheck and buy your company stock as a long-term investment?"
Oftentimes when I ask that question, clients go, "No way. That's not something I want to do." Right there, we have our answer. If you're not willing to do that, then you shouldn't hold your company stock.
Jag: That is a really powerful point to leave it on, Amy. This goes back to something we've talked about for a hundred-some-odd episodes at this point, which is really understanding your behavior, the psychology of your investing, the “why.” Every piece of your financial plan has to have a why, and that's why I love working with you because you take that into account instead of just, ticking a bunch of boxes or whatever it is. You really get to know your clients. I think that's one of the advantages to working with you at Thimbleberry Financial.
If somebody listening wants to come talk to you about their financial future, about ESPPs specifically in this space, or even in general, what are the best ways to find you?
Amy: They can find us online at thimbleberryfinancial.com or by giving us a call at 503-610-6510.
Jag: Good stuff, Amy. We'll talk again in a couple of weeks.
Amy: Sounds great, Jag. Look forward to it.