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

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?

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

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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. As of September 2017, that means they’re taxed at 20%, 15% or 0%, 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 postand 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.

the ins and outs of espp’s, part 1

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?