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?
Financial Geekery 
I use ESPP as a sort of forced savings plan. The amount that my employer allows me to buy just about covers our property taxes and church giving, so I sell whenever it’s time to pay the tab (generally alternate years as we “bunch” tax deductions). There is a little extra risk involved in the way I do it, but I figure the chance to pay long term capital gains tax on some of it will compensate (and if I can donate shares to the church and keep the LTCG off our return entirely, so much the better).
Not a bad idea, assuming you have a cash reserve in place to take care of property taxes in the event that the company goes bankrupt. 🙂
I like that! Definitely follows the Buffet Rule #1 (“don’t lose money”). So do you sell the rest immediately once they become a qualified distribution? (Whoops, meant that to be in reply to Perrenialguy.)
My strategy has been is to sell just enough ESPP shares to recover my principal investment. I leave the rest for long term tax treatment.
So, I will admit that after seeing your part 2 article, I felt emboldened to hold onto my ESPP shares until they became a qualifying distribution for tax reasons (except when the price drops between offering and purchase date, when taxes on a non-qualifying distribution are lower). However, I just came back to this and now realize the difference is incredibly small.
How small? The tax advantage of lowering the portion taxed at ordinary rates by holding until it is qualified is equal to the difference between my long term and short term rate (usually between 10-15%), multiplied by the ESPP discount rate (15% for me), multiplied by the difference in stock price between offering and purchase date (usually no more than 10-15% even in a bull market). That means if the stock price drops by more than 0.4%, any tax advantage of holding until it becomes qualified has been wiped out.
I have been lucky so far in this market, but now that I see how tiny that tax benefit is, I’m going to start liquidating all of my ESPP shares and sell as soon as they are granted in the future. The reward just seems tiny compared to the risk. Plus, filing taxes is easier since my employer reports the appropriate W-2 income on non-qualified distributions.
Good on your for doing the analysis! I have a spreadsheet that I use to run the numbers for any given client situation, and the risk/reward analysis definitely varies quite a bit, depending on grant price, discount, tax bracket, and general behavior of the stock in question.
any chance you would share this spreadsheet?
You bet! It’s on my list to make it user-friendly and share it out. 🙂
Great post. Thanks for explaining qualifying vs disqualifying in a graph form. My employer gives me a 15% discount – so the day after purchasing, I sell just enough to get my principal + 12% (better than any bank/fund in the US). I realize it is disqualifying disposition but really doesn’t matter to me. The remaining is literally free money in my mind – never had to work for that (and remember, I still took ROI on my principal – so didn’t lose any money had I invested it some other place). After 6 years, I ended up with 150 “free stocks” and the stock price has gone up by 7x. ESPP has been awesome so far!!
For me, I hold the stocks long enough to reach long term capital gains but not long enough for them to become “qualifying dispositions.” As others have noted, the tax offset of waiting for it to be a “qualifying disposition” usually just isn’t worth it.
Using this method, I basically sell immediately (almost, usually let the stock stabilize for a couple of days since my buy date comes on the heals of earnings, unless its way up of course) but only after I’ve been enrolled for 18 months. This way I am always selling the oldest lot I have at a preferential tax treatment and collecting the hopefully additional gains of being invested in my company. The amount or rather value of company stock I hold stays relatively static at whatever my annual contribution level is.
Month 0 – Enrolled
Month 6 – Buy Lot 1
Month 12 – Buy Lot 2
Month 18 – Buy Lot 3, Sell Lot 1
Month 24 – Buy Lot 4, Sell Lot 2
Month 30 – Buy Lot 5, Sell Lot 3
and so on.
I am taking a theoretical risk that the company could go bankrupt between periods but realistically that risk is small. If I were concerned about the company disappearing, #1, I probably would have disappeared as an employee off to another company with a brighter future before the next buy, #2, I can always sell in advance of my shares reaching long term capital gains should such a situation arise (which with the exception of sudden bankruptcies like Bear Stearns, is probably somewhat known to employees within the company) and #3, even if I were to lose those shares entirely, I can use the loss to offset my gains elsewhere in my portfolio as well as the $3000 loss-limit in income while still carrying forward any remainder to future years.
The biggest risk I take is that the stock goes up/down between periods and I kick myself for selling/not selling the lot at the last period but that’s all about timing the market and no one I know can successfully do that. Of course there also is nothing stopping me from selling a lot prematurely if the price drops significantly but as long as the market and stock is going up, I find my method strikes a nice balance.
A nice balance, indeed. You might consider a second-order analysis on sell immediately v. wait for long-term gains v. wait for qualifying disposition. The answer depends on a number of variables. What’s your company’s volatility? How much is your discount? What’s your current ordinary income tax rate? How much is actual dollar benefit of a qualifying disposition v. immediate sell v. wait for long-term gains? Your approach is likely a good balance, but if you want to by truly systematic and play the odds in a way that will consistently win out over the long term, I suggest running the numbers using your company’s historical data.