How Does an ESPP Work? - SmartAsset

As part of your company’s benefits package, you may have access to an Employee Stock Purchase Plan, or ESPP. These plans allow you to purchase shares in the company you work for, typically at a discount. An ESPP is separate from a 401(k) or similar workplace retirement plan, but both can be useful to growing wealth over the long term while enjoying some tax benefits. If you have access to an Employee Stock Purchase Plan at work, it’s helpful to know how to use it to your advantage. If you want hands-on guidance as you negotiate whether an ESPP is for you, consider enlisting the help of a trusted financial advisor.

Employee Stock Purchase Plan (ESPP), Definition

An ESPP is a program some companies offer to allow their employees to buy company shares, usually for a discounted rate. For example, you may be able to buy shares in your employer’s company for 10% or 15% less than what you’d pay to purchase the same shares through a brokerage.

The money that’s used to buy stock through an ESPP comes right out of your paychecks. Depending on how the plan is structured, all of a company’s employees may be eligible to participate in an Employee Stock Purchase Plan. Though you should check with your plan’s administrator to make sure you qualify in case there are restrictions on who can participate.

How an ESPP Works

Employee Stock Purchase Plans let you buy shares of stock in your employer using payroll deductions. These are after-tax deductions, meaning you’ve already paid taxes on the money that’s being used to buy the shares.

You can make payroll deductions to fund an ESPP during what’s known as an offering period. During this offering period, which can last anywhere from six to 18 months, your payroll deductions accumulate. Then, on a set purchase date those funds are used to buy shares of stock in the company at a discount to the current market price.

The amount you can deduct from your paychecks to purchase shares through an ESPP is determined by the plan. The IRS also places its own limits on ESPP purchases. You can’t purchase more than $25,000 in shares of stock through an Employee Stock Purchase Plan during a given year.

Qualified vs. Non-Qualified ESPPs

It’s important to know that an ESPP can be qualified or non-qualified. This difference can affect how your stock shares are taxed if and when you sell them at a profit later.

Qualified ESPPs offer favorable tax treatment to employees. When you buy stocks through a qualified plan, you wouldn’t owe taxes on the discount at the time of purchase. You’d only pay it when you sell your shares and then it would be taxed as ordinary income.

If you hold the shares you purchased for at least one year from the purchase date and two years from the offering date, you could take advantage of the long-term capital gains tax rate if you sell them for more than you paid for them. The long-term capital gains rate is lower than the short-term capital gains rate, which taxes investment gains like ordinary income. Avoiding the short-term capital gains rate is a good thing if you’re in a higher income tax bracket.

Non-qualified ESPPs can be structured like qualified plans and operate the same way but they don’t yield the same tax benefits. That means no special treatment when it comes to taxable capital gains.

Remember, you can generally sell shares purchased through an ESPP at any time unless your company restricts you to specific trading windows. But the amount of taxes you might pay on the sale depends on whether you have a qualified or non-qualified plan and in the case of a qualified plan, how long you’ve owned the shares.

Benefits of an ESPP

The biggest advantage of using an ESPP to buy shares in the company you work for is the chance to get them at a discount. So if your company’s stock is trading at $100 per share, for example, and you get a 15% discount through your plan you could buy those same shares for $85 each.

That’s a huge plus if you want to start investing and you don’t have a lot of money to throw at the market. And if you do have money to spare, you could use an ESPP to complement your 401(k) or an individual retirement account to build wealth that much faster.

One thing to watch out for, however, is getting overweighted with company stock in your portfolio. If you’re not balancing out contributions to an ESPP with other investments outside the plan you could be raising your portfolio’s risk profile. If your employer were to suffer a large financial hit unexpectedly, that could plummet the value of your shares and cost you money in the process.

If you’re considering an ESPP, it’s important to remember to stay diversified. That way, your other investments can help to balance out potential losses if your company’s stock underperforms.

ESPPs vs. ESOPs

An Employee Stock Ownership Plan, or ESOP, is another benefit your employer may offer. While it sounds similar to an ESPP, it’s not the same thing.

With an ESPP, you’re not buying shares in your company. Instead, your employer sets up a trust into which stock shares are transferred. Those accumulated shares are then divided among employees.

Your shares remain in the trust as long as you’re employed by the company. If you leave the company to work elsewhere or retire, you’ll typically have the option to sell your shares back to the company or trade them on the open market. You’re not taxed until you sell your shares. The capital gains tax rate would apply but you could defer taxes by rolling shares over into an IRA.

The Bottom Line

Companies often use an ESPP as an incentive to attract and retain talent. If you have access to an ESPP at work, it could be a valuable tool for increasing your portfolio over time. ESPPs and ESOPs both offer some tax advantages. And they can increase the overall value of your employee benefits package. If you’re offered either one as a new hire, it’s important to understand which one you’re investing in and make sure you understand how your withdrawals will be taxed if you decide to sell some or all of the stocks you’ve purchased.

Tips for Investing

Consider talking to a financial advisor about the pros and cons of investing in an ESPP if you have access to one through your employer. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s financial advisor matching tool can help you connect, within minutes, with professional advisors in your local area. If you’re ready, get started now.
When investing in your workplace retirement plan, take time to review your investment options and the fees you’re paying at least once each year. It’s important to make sure the mutual funds or other investments you purchased when you initially signed up for the plan still meet your needs. A free investment calculator can help you with periodic portfolio checkups.