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the ins and outs of espp’s, part 3: so now what?

May 29, 2012 by brittongregory

So I gave you a summary of what ESPP’s were all about, then went into detail on the intricacies of ESPP’s and taxes. Now: what exactly are we to do with all this information? Should you participate in your company’s program, or not? And if so, how long should you hold on? Well, everyone’s situation is different, but for most people, I would say this: participate in your company’s plan as much as you are able, and sell as soon as you can. I’ll break down the reasons why, so you can see whether this applies to you in particular.

Participate, because it’s free money. The discounted price at which you get to buy the stock is, if you sell immediately, almost always guaranteed free money. (Among the exceptions are companies with extremely volatile or rarely-traded stock.) If you don’t participate, you are, as they say, leaving money on the table. Obviously you don’t want to go into debt over it, but if you can swing it, do it!

Sell immediately, because to do otherwise is to greatly increase your risk. Holding onto these shares is, in most cases, a highly risky proposition. Yes, holding onto them for long enough to make a qualified disposition may give you some tax advantage, but is it really worth dealing with the ups and downs of your company’s stock?

Moreover, if you think of an “investment” as a “source of future income”, you’re already highly invested in the company you work for. For diversification’s sake, do you really want to put even more eggs in that basket?

“OK,” you may say, “but what do I do, then, with this sudden influx of cash?” Well, your first instinct may be to splurge — and if so, that’s OK. Set aside some amount you feel comfortable with — say, 5 or 10% — and go for it. Consider giving some of it away, as well; chances are, if you have access to an ESPP, you’re in a position to help other folks out. Set the rest aside – either for basic financial goals or long-term ones, like retirement or your children’s education.

Of course, I know several engineers who quite simply and literally have more money than they know what to do with. You know who you are — and that’s perfectly OK. I may go into more detail on recommendations in a future post, but for now (assuming you’re already maxing out what options you have in the way of tax-advantaged accounts), I’ll just recommend parking the money in a well-diversified balanced stock-bond fund, such as the T. Rowe Price Balanced Fund, the Vanguard LifeStrategy Moderate Growth Fund, or the Fidelity Balanced Fund. Any of those will give you a nice, simple, inexpensive compromise between returns and stability until you decide you want to pull that “mad money” out.

Now that I’ve said that: what do you currently do with your ESPP, if you have one? Has this post given you any new ideas?

Posted in Geekery, Investing | 2 Comments »

Announcing the Summer Workshop Series!

May 24, 2012 by brittongregory

That’s right, the “Freedom from Bondage” personal finance workshop series is back! Know any Austinites who’d like to get a handle on their money, whether it’s automating their bills, breaking the debt cycle, or even reconciling their faith and their finances? Then send them here: www.financialgeekery.com/summer2012.

(If you want to nudge your friends in this direction in a more subtle manner, just click one of the “share” buttons below!)

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the ins and outs of espp’s, part 2: fun with taxes!

May 15, 2012 by brittongregory

In the last post, we talked about the basics of ESPP’s, and I warned you that the tax situation warranted a post in and of itself. Well, here it is! With a few pictures, hopefully it will come clear.

Let’s start with the basic diagram below. At this level, the tax situation is rather simple: the difference between the price at which you bought the stock and the price at which you sold it is income, and thus is taxed.

Sounds simple, right? Well, the trick is how it is taxed. There are three options:

Compensation (ordinary income): Part of your ESPP income is taxed as compensation, i.e. at your normal income tax rate.

Short-term Capital Gains: If you held your shares for a year or less after you purchased them, the part of your ESPP income not taxed as compensation is taxed as short-term capital gains. Currently, that means they’re taxed at the same rate as compensation.

Long-term Capital Gains: If you held your shares for more than a year after you purchased them, the part of your ESPP income not taxed as compensation is taxed as long-term capital gains. Currently, that means they’re taxed at 15% or 5%, depending on your income.

OK, that doesn’t sound so bad. So that means that all we have to do is figure out how much of the income is compensation, and we’re home free, right? Well, yes…and that’s the tricky part. There are two situations we need to go into: “disqualifying dispositions” and “qualifying dispositions”.

Disqualifying Dispositions: If you did not hold your shares for more than two years after the “grant date” (beginning of the offering window; see previous post) and more than one year after purchasing them, this is a “disqualifying disposition”. In a disqualifying disposition, the difference between the amount you paid for the shares and the amount they were worth when you bought them — in other words, your discount — is counted as compensation income. The rest — the difference between the amount the shares were worth when you bought them and the amount they were worth when you sold them — is capital gains; long-term if you held the shares for more than a year after purchasing them, short-term otherwise.

Sounds relatively straightforward, but what if your stock drops after you buy it? Well, the sad fact is that it the discount still counts as compensation income, even though you didn’t see a red cent of it! To be sure, the capital losses offset your income — but only up to $3,000. (The rest must be carried over to future years.)

Qualifying Dispositions: If you held your shares for more than two years after the grant date and more than one year after purchasing them, this is a “qualifying disposition”. In a qualifying disposition, your compensation income is equal to the difference between what you paid for the shares and what you sold them for or the discount (difference between what you would have paid for the shares and what they were worth) on the grant date, whichever is lower. The rest is long-term capital gains since, by definition, you held the shares for longer than one year. So an ideal situation would look like this:

That’s good — more of your income is taxed at the (lower) long-term capital gains rate. But here’s a bizarre twist: in the following situation, you would actually pay more in taxes for a qualifying disposition than for a disqualifying disposition!

Note that if this were a disqualifying disposition, your compensation income would be much smaller (look back at the second graph), and the capital gains much larger. Ouch — good things do not, apparently, always come to those who wait!

And that’s how ESPP taxes work. You’ll remember that forever, right? Well, if perchance you think something more important might displace its spot in your memory, feel free to bookmark this article and refer back to it later. (Heck, I’ll probably end up doing that myself!)

So…now what? This theoretical knowledge is all well and good, but what we should actually do with our ESPP shares? Do we participate in our company’s ESPP, or no? Do we sell some or all of the shares immediately? How long should we hold on to them? I’ll discuss all of these questions in the final post in this series.

Posted in Geekery | Leave a Comment »

the ins and outs of espp’s, part 1

May 3, 2012 by brittongregory

Employee Stock Purchase Plans are, like much in the stock-related world, a double-edged sword. Depending on how you swing them, they can either be a handy supplement to your paycheck or just another source of complexity and, in the worst case, a way to flush income down the drain. As many of my fellow geeks have access to them — though not as many as a decade ago — I’d like to take some time to talk about them. Even if you’re already familiar with ESPP’s, it’s a good idea to know what’s out there – not every company’s plan works the same as yours, and it’s handy to know what the possibilities are when you’re job-hunting!

The idea behind the ESPP is relatively simple: as part of the benefits your employer is showering upon you — like manna from the heavens — you are given the opportunity to buy their stock at a discount. Nothing in the world of employer benefits is ever that simple, of course, so I’ll walk through the caveats.

The money for purchasing this stock is withheld from your paycheck. In this way, ESPP’s are much like 401(k)’s: you allocate a certain amount of your paycheck to be withheld, and that amount never graces your bank accounts. Also, there are heavy restrictions on when you can change that allocation; generally you can jump out if you like, but you can’t jump back in until the beginning of the next ESPP period.

The stock is often (not always) purchased in one chunk, at the end of the ESPP period. In this case, rather than buying stock each time you get a paycheck, it’s all purchased at the end of an ESPP period (generally 3 or 6 months). You can expect to see fun little jumps in your employer’s stock price on that day, as some/many/most employees (depending on the company) turn around and sell their newfound shares (and speculators buy or sell in response to this).

There is a cap on how much you can purchase. The cap can be either a maximum percentage of your paycheck, or a maximum number of shares bought, or both.

The discount varies greatly with the employer. Most common is a range from 5%-15%; alternately, the company may “match” your contributions to the ESPP up to a certain percentage of your income. Also, the discounted price is not always the fair market value on the day the stock is bought; it could be the lower of that price and the price at the beginning of the period, or even the price at the beginning of a window of periods! For example: say your employer’s stock price was $10 when you joined a year ago, $20 at the beginning of the last period, and $30 today, the end of the latest ESPP period. Depending on your employer, the buy price could be 5%/10%/15% of $30, $20, or even $10!

Depending on the company, it may not be a guaranteed win. In most cases, if you sell immediately you’ll lock in your profit and get a nice bonus. However, if you work for a company with a highly-volatile stock price (e.g. a “microcap”), you can lose your discount (and more!) by the time you sell your stock.

The taxes on ESPP’s are…interesting. So interesting, in fact, that I’ll be devoting my entire next post to them!

See you then! In the meantime, tell us about your ESPP — has it done well by you? And does it fall into one of the above descriptions, or is it a variant that wasn’t covered?

Posted in Geekery, Investing | 6 Comments »

some perspective on investment choices

April 17, 2012 by brittongregory

99% of the time, when people talk about investing, they talk about investment choices. What are you investing in? What do you buy or sell, and when? Have you found the next Apple or Google? It’s fun to talk about — a co-worker of mine recently told me about how he invested in copper mining companies in anticipation of the Beijing Olympics — but I’d like to offer some numbers, and some perspective.

To keep things simple, let’s say you’ve got a retirement investment portfolio that returns 10%, year-on-year. Of course, no portfolio is actually going to do that — anything returning 10% is going to carry a lot of risk, and thus, will vary quite a bit from year to year — but that’s okay for what we’re looking at. For this imaginary portfolio, if you invested $200 every month — $2400 a year — after 30 years, you’d have $452,098. (Edit: of course, the assumption that you’re investing a constant amount for thirty years, rather than increasing your investment as your income increases, is also unrealistic (not to mention unwise!). But again, this is okay for our purposes.)

Not too shabby, but most people I know would want more in their retirement accounts before they’d feel comfortable calling in rich. The first thing people generally think about is how to increase that return rate. Maybe you have an awesome hedge fund, or a killer advisor, or the perfect asset allocation, or you consistently pick more good stocks than bad every year for thirty years. If they’re really, really good, maybe you’ll get an extra 2%, net of fees (whether they’re charged by the hedge fund, your advisor, or your brokerage for all those trades). Now, that may not sound like much, but don’t be fooled — that extra 2% will get you $689,993, almost $250,000 more than (over 1.5x) what you would have gotten otherwise. (For the rest of this illustration, though, let’s assume you didn’t get lucky and are earning 10%.)

But wait — we forgot about taxes. If this is after-tax money in a Roth IRA, then our illustration still stands. But what if it’s in a normal brokerage account? Well, at current capital gains rates, 15% of your returns would go to Uncle Sam every year, bringing our nominal 10% rate down to 8.5%. (Edit: to be fair, this is an unrealistically worst-case scenario. By letting your money compound for as long as possible before selling, you can reduce this hit significantly.) Suddenly, your ending portfolio goes down to $330,141; you’ve lost over $120,000, almost a quarter of that bundle.

OK, so we definitely want to take taxes into careful consideration. But what if we go a step further and boost our savings rate — maybe we invest in a 401(k) with a company match, or simply max out our allowable IRA contributions? Well, if we upped that $200 to $400/month, we’d end up with $904,195. (Yes, that is exactly twice the $200/month number — the distributive property in action.)

Alright, that’s almost a million dollars, and it’s all in tax-advantaged accounts. But there’s one more thing we can do — what if instead of increasing our savings, we had just started investing earlier. Thirty years represents a 35-year-old waking up one day and saying, “hey, if I want to retire at 65, I better get a move on” — what if we started saving $100/month right out of college? After 44 years, you would have one million, eight hundred ninety-five thousand, five hundred and three dollars.

I can’t make the point any clearer: start saving for retirement now. Even if you can only go with $50 or even $25 a month — start with the basic advice here, and refine your investing strategy as you go. Yes, investment choices, taxes, and putting a lot away are all important, but they all pale in comparison to starting as soon as you can (and gradually increasing your contributions over time).

Photo by Journey Photographic.

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the academic and the businessman: two views on investing

April 3, 2012 by brittongregory

In case there was every any doubt: investing is not an exact science. After all, it depends quite literally on predicting the future, and as the Galbraith quote goes: “The only function of economic forecasting is to make astrology look respectable.” So it’s no surprise that there are as many ideas on investing as there are people, which can make for a lot of confusion. Let’s take a look at two of them: what I’ll call the Academic and the Businessman.

The Academic looks at investing in a very abstract sense. His main goal is to balance risk versus reward, using his knowledge of Modern Portfolio Theory. He knows that the two often go hand-in-hand, but that diversification is key, which will greatly reduce the risk while still keeping a good reward over time.

The Businessman, however, knows that owning stock is like owning a business. He does a good deal of research on each purchase he makes, and he makes sure to understand the business model of each company he invests in.

When purchasing a stock, a Businessman will often look at the “fundamentals”, aspects of the company such as earnings, cash flow, debt, assets, and dividends. The Businessman is especially interested in stocks that are priced lower than they should be — either because the company is out of favor (e.g. Ford during late 2008), or because its growth is even higher than expected (e.g. Apple, starting at around the same time). They look down on “di-worsification”, buying stocks in companies without a rock-solid reason for each purchase.

An Academic, however, rarely purchases an individual stock. He concerns himself more with the proportion of various asset classes (large and small, domestic and international, “value” and “growth”, and most importantly, stock and bond) in his quest to balance risk and reward. He believes that in this modern era of free-flowing information, picking an individual stock that significantly outperforms its current price is generally due to luck, and thus that consistently doing so is nearly impossible.

If you’re looking at investing sites on online, you’ll find a lot of Businessmen in the “Motley Fool” community, as well as in the sizable group of those who look to Warren Buffett for their investing inspiration. Meanwhile, the community known as the “Bogleheads” (after Jack Bogle, founder of Vanguard) fall firmly the Academic camp, along with academic researchers exemplified by Eugene Fama and Kenneth French.

Me? I’m an Academic…mostly. The research is compelling, and I trust it more than I do Wall Street or most financial publications. That said, I keep a small part of my portfolio set aside for specific companies to scratch the Businessman itch!

How about you? Are you an Academic, a Businessman, both, or neither?

Posted in Investing | 7 Comments »

serenity and the stock market

March 20, 2012 by brittongregory

God grant me the serenity to accept the things I cannot change,
Courage to change the things I can,
And the kind of money where I don’t really care either way.

OK, not really, but yesterday’s announcement that Apple would be giving some of its tens of billions of dollars back to its stockholders in the form of buybacks and dividends sparked a conversation with a friend of mine, so I thought it would be a good time to talk about emotions and the stock market.

Anyone with spare cash will often find themselves invested in the stock market. Those who are compensated partially in stock (hello, fellow engineers!) pretty much have no choice. And everyone will, sooner or later, find themselves selling that stock at a particularly bad time, and slapping themselves in the face because of it. “If only I had sold sooner/later!” How do we avoid this?

First, know that you’re going to get it wrong sometimes. People have varying takes on how efficient the market is, how predictable it is, and how much it’s just a random walk (see Burton Malkiel). I side with the random walkers, but pretty much everyone admits that there’s some amount of “noise” in the market, some amount of movement that you simply cannot predict without getting lucky. Accept that and move on. Yes, you could have timed things better, or put more into this stock when it was low, but you didn’t have a crystal ball, so don’t beat yourself up over it.

Accept that you are heavily biased. Humans have all kinds of cognitive biases, and most of us refuse to believe that we’re affected by them. A particularly deadly one is the fact that we tend to ”accept wins at face value and tend to explain away losses”, per this paper among others. In the stock market, this encourages us to take more risk than we really should, and to overestimate our skill. The first step to countering this is to acknowledge our weaknesses. The second step?

Develop a plan, stick to it, and leave your emotions at the door. Do NOT go with your gut; when it comes to the stock market, your gut is lying. Make a plan: I will buy at this predetermined point, and I will sell at this point. (“Dollar-cost averaging into a broadly diversified portfolio and regularly rebalancing” is a good start.) If the market starts plummeting or soaring, keep ignoring your gut: following the crowd is a recipe for buying high and selling low. (And make no mistake: blindly doing the opposite of the crowd is almost as bad.)

Diversify. There’s a common saying in the financial planning world: diversification is the only free lunch. If you have individual stocks, keep them under a small percentage of  your portfolio (say, 5%), and during your regular rebalancing session, make sure they don’t exceed that percentage. [Edit: This means the rest should be in a diverse allocation of mutual funds. I'll talk about that more in a future post.] This has several advantages: it will help you limit your risk of a single company causing your portfolio to nosedive, it’ll help you sell the winners at a good time, and it’ll help you obsess a little less over your company’s fortunes. Speaking of which:

Don’t own stock in the company you work for. Unless stock options are your main form of compensation, you’re already heavily invested in your company: they’re the ones writing your paycheck! Don’t double down, even if you work for Apple: if your employer gives you stock, in the form of options or ESPP’s, sell it as soon as it vests and invest it elsewhere. (Worried about taxes? You shouldn’t be. I’ll cover that in a later article.) For every story of an employee who retired rich off his company’s stock, I can give you 10 (at least!) of employees who wiped out their wealth by failing to diversify in this way.

Above all: unplug, unplug, unplug. Watching “Mad Money”, reading articles like “5 Stocks To Watch”, and the like will just give you heartburn and tempt you to ditch your plan. They certainly won’t help you make money; make no mistake, they’re entertainment. Following the latest trends just leads to buying high and selling low, because there are thousands of people watching and reading the exact same media. Get the information it takes to follow your plan, only as often as your plan requires. (Hint: if it involves checking prices and other research more than once a quarter, it’s probably too involved.) If you think you may want to change your plan, force yourself to go slowly: wait until next quarter — or next year! — before even beginning to implement that change.

In other words: mind the gap.

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