Monday, January 23, 2006

The Wonderful World of Employee Stocks, Part 3: Don’t Poo-Poo Your ESPP

Author: Nick
Category: Money
Topics: ,

Oh how I wish my employer offered us an Employee Stock Purchase Plan (ESPP). I mean, an ESOP is better than nothing, but there are absolutely magical things about ESPPs that make me jiggle like a bucket of Jell-O just thinking about them. Today we’ll take a look at a few of the magical, jiggle-inspiring facets of ESPPs along with a few jiggle-stopping pitfalls to watch out for in your own ESPPs.

How ESPPs Differ From ESOPs

Comparing ESOPs to ESPPs is a bit like comparing apples to apples full of free money. We’ll get more into the free money side of ESPPs in a bit, but suffice it to say that ESOPs and ESPPs have a few basic characteristics in common. To start, any money you may have in either will grow or shrink depending on the success of your company, so employers hope that participating in either plan will encourage their workers to strive for peak productivity. So if you work hard enough to compensate for the other thousand slackers around you, your company’s stock will skyrocket, and you will hit it big. Right? Right. Moving on.

ESPPs involve more direct interaction with your company’s stock than ESOPs provide. Shares are typically purchased using money right out of your paycheck at the start of a plan period. Plan periods typically last a period of six months, but this doesn’t mean you have to actually own the stock for six months or that you have to sell it after the period is over. Instead of being a part of a big trust like an ESOP, you take direct ownership of the stock yourself in an ESPP. While the company will hang on to the stock for you, you are a shareholder with all the rights and privileges that come with that title. So feel free to vote your goldfish into the board of directors or start labeling company office supplies that you now “own.”

FREE MONEY! Now That I Have Your Attention…

…I’d like to talk to you about … free money! How much free money am I talking about? Well, it sorta depends on how you look at things. How does a 15%+ return on your investment sound? How about a 60%+ return? You technically get both of them depending on how your ESPP works, and here’s how.

Many ESPPs allow employees to purchase company stock at a discounted rate. While some companies have been dropping this discount lately, a 15% discount is not uncommon. The actual price you pay for the stock when you purchase it is not as simple as looking at your favorite newspaper’s stocks page on the first day of the plan period. A lot of companies will let you purchase the stock at its price (minus any discounts) on either the first day or last day of the period, whichever is cheaper. A few employers throw in some oddball modifications to this rule; if you’re lucky, you might only pay the lowest price on any Friday during the plan period or maybe even the lowest price a year or two into the future!

The real fun with ESPPs comes in when you do something that you’re really not supposed to when participating in an ESPP: selling your shares as soon as you purchase them. If you just bought a share of The Baggy Black Pants Company that sells on the open market for $20 and you get a 15% discount on your purchase, you spent $17 to buy something that is immediately worth $3 more. If you sell that share right away for $20, you just made 17.6% on your $17 investment.

Where does the 60%+ return come in to the picture? It depends on how your ESPP paycheck deductions work and how long your money is really tied up in the plan. If your plan period lasts six months and you contribute to it in weekly paycheck deductions, your money is really only tied up for an average of three months. Assuming you sell right away, and putting your discount into the equation, you stand to make 15% or more for a three-month investment; that’s a 60% annualized return on your money! If you take into account more complex Internal Rate of Return calculations, you might even be looking at a 93% return on investment. The best part: because of that 15% discount, that return is guaranteed and doesn’t depend the tiniest bit on the stock’s performance.

You can also play with ESPPs the way they were meant to be played with: hold on to the stock for some period of time longer than six seconds. Obviously this entails more risk, but some people see their discount as a sort of buffer that helps protect against a big loss.

Traps and Taxes

Earlier I hinted at the fact that immediately selling ESPP shares to cash in on the discount goes against the rules of ESPPs. While most companies don’t have regulations on how long you must hold on to your ESPP shares, flipping shares is supposedly not in the “spirit” of an ESPP. ESPPs are really designed to be vehicles of long-term growth that encourage employees to hold stock in their company. Despite this, there are plenty of people out there who continue to flip their shares for an immediate, guaranteed profit and they’ll keep doing so…

…Until the company gets tired of it. More and more, businesses are adding caveats to their ESPPs to discourage employees from immediately selling their purchased shares. RS of the Young Professionals Financial Blog shared some comments about IBM’s ESPP clause that kicks its employees out of the plan for the rest of the six-month period if they sell their shares immediately. Couple that fact with IBM’s less than thrilling 5% discount on its ESPP shares and you have a much less attractive plan. Still, taking into consideration the annualized return, even a 5% discount can return 20% or more per year.

As with the rest of the money we make in life, the federal government will always be there waiting (hopefully not right outside your office door) for its chunk. The tax implications for individuals participating in ESPPs can be a bit tricky, so I’ll leave the details to this very thorough article on the TurboTax website. To summarize, the money you make from the share price discount is generally considered additional compensation and you’ll pay taxes on it like regular income. If you hang on to your shares for a while and make a profit because the stock’s value increased, you may get away with paying just long-term capital gains taxes on those profits depending on how long you hold the stock. For many people, long-term capital gains are taxed at a lower rate than your boring old paycheck.

There are a couple other things to consider before running through your hallways at work shouting “Free money! Free money!” The first is that you may have to pay a commission on your stock sale. It’s probably going to be a flat rate, and if you’ve been putting enough out of your paycheck into the ESPP, it won’t be much compared to your net return. But if you think you’re going to make money getting a dollar taken out of your pay each week for six months, even a 15% discount can evaporate in the face of a $10 commission.

You should also watch out if your company messes around with the traditional rules of an ESPP. Especially in times of financial trouble, a company can pull some nasty tricks on you that will cheat you out of your discount and possibly part of your original investment. For example, while most ESPPs will issue the stock right away, some might take up to a couple weeks to do so. Sometimes a company will apply black-out dates preventing employees from immediately selling. In the meantime, the stock price drops and you’re out not only the free money but some of your own money, too. As advised in this article on ESPPs from Ask Tog, be sure that your ESPP issues stocks on the payout date and that there aren’t any rules that absolutely prohibit you from immediately selling them.

Summary of ESPPs

If you skipped down to hear without reading the rest of the article, you’re cheating! Go sit in the corner and think about what you’ve done. Then come back and read this summary anyway.

  • If you’re in an ESPP, then you own stock. None of this wussy fake-owning like in an ESOP. The stock is in your name, but your company will likely hold on to it for you until you’re ready to sell it.
  • ESPPs generally mean free money. Assuming you don’t have a really awful ESPP that gives its employees no discount on purchased shares, you make risk-free money just by buying and immediately selling. If your company has a plan like this and you’re not participating, you’re just silly.
  • When you make money, you pay taxes. This unofficial slogan of the IRS is just as true for your ESPP winnings. While the amount you pay can vary, you generally pay regular income tax on any money you make from the price discount and long-term capital gains tax if you hold on to your stock for a while.
  • Read the fine print of your ESPP. Some companies will temporarily throw you out of the ESPP if you immediately flip your shares after purchase. Other, shadier companies might pull tricks that could cost you your return on investment and then some! Be sure to know the rules of your ESPP before participating.

The series on employee stock plans comes to a close next time when the topic will be stock options. Be sure to exercise your option to check it out!

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