What Are ESPPs?

When you start a new job or even before you accept the job offer, one of your first tasks should be to familiarize yourself with your benefits package. Companies can offer a number of perks to their employees, from matching 401(k) contributions to offering discounted gym memberships. If it’s a publicly traded company, you may get stock perks like an employee stock purchase plan, or ESPP.

“Companies can use an ESPP to help participants save over time and as an incentive for employees to want to contribute to the success of the company,” says Kathleen Stewart, a senior wealth strategist with BNY Mellon Wealth Management.

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What Is an ESPP?

“An employee stock purchase plan is a company benefit program that allows employees to purchase shares of the company’s stock through direct payroll deductions that are sometimes purchased at a discount of up to 15%,” says Josh Simpson, vice president of operations and investment advisor with Lake Advisory Group. “Oftentimes these are offered by companies that are not listed on any of the major exchanges such as Publix, a supermarket chain in the Southeastern U.S.”

ESPPs can be qualified or nonqualified. In qualified plans, you won’t have to pay any taxes on the discount you receive by purchasing through the plan. With nonqualified plans, the difference between the stock’s fair market value and discounted price of the stock offered by the ESPP is taxed as ordinary income.

“The qualified plans will have more rules that have to be followed to maintain their tax-preferred status,” Simpson says. For instance, qualified plans require shareholder approval before they can be implemented and limit the offering period, or length of time you’re allowed to contribute money into the plan.

The IRS also limits how much employees can purchase to $25,000 per year. This amount is lowered by the discount offered, Stewart says. “For example, if the purchase price discount was 15%, the ability to purchase would be limited to $21,250.”

[READ: Deciding Between a Roth vs. Traditional IRA.]

How Does an ESPP Work?

Many companies require employees to have worked for the company for a certain amount of time before they can participate in the company ESPP. “It could be 90 days or it could be a full year; it just depends on the company and their rules,” Simpson says.

“Once an employee decides to participate in the stock purchase plan, they will set up payroll deductions that will build in an account until the purchase date,” he says. At the purchase date, the company uses the funds in the employee’s account to purchase shares of the company’s stock at the predetermined discount. The shares are generally then deposited into a brokerage account in the employee’s name.

Qualified ESPPs may also offer a lookback period that lets the plan use a past price to determine the actual purchase price an employee would pay through the ESPP. If a lookback period is offered, the stock price is set at the lower of the date you started contributing to the plan or the date your purchase is made.

“If the share price moves up during the purchase period, the participant will benefit from the gain because his or her cost will be lower,” Stewart says. “Alternatively, if the share price goes down, they will still benefit from any available purchase price discount.”

You won’t pay any taxes on your ESPP shares until you sell them, at which point your gain may be taxed at ordinary income rates or the lower capital gains rate. To qualify for the lower capital gains rate, you’d need to have held your shares for at least two years from the grant date, which is the first date you were able to start contributing to the plan, and at least one year after purchasing the stock. Note that the discount is always taxed at ordinary income tax rates.

Stewart offers an example to illustrate: Assume you purchased a share of your company stock at a 10% discount with a purchase price of $100. You’d pay $90 for the stock after the $10 discount. Later, you sell the stock for $125, earning a $25 post-purchase appreciation in addition to the $10 discount.

If you did not meet the holding period requirements, your $25 gain and $10 discount would be taxed at ordinary income rates. If, however, you did satisfy the holding period requirements, the $10 discount would still be taxed at ordinary income rates, but the $25 gain would receive the more favorable capital gains tax rate.

How to Use ESPPs?

ESPPs can be great ways to get discounted company stock. Accumulating shares over time through an ESPP can add value to your overall holding, especially when you make consistent, ongoing contributions. That said, “although ESPPs can be a great vehicle to build wealth, participants need to consider their own individual circumstances to avoid unnecessary risk,” Stewart says. “As a concentrated position becomes larger over time, the participant should weigh risks associated with holding a concentrated position and have a plan for diversification.”

If something were to happen to your company or its stock were to fall out of favor in the market, you could still lose money on the investment, even after whatever discount was applied.

“Caution is the rule when dealing with any concentrated holding, especially if an investor is also accumulating or holding company stock in their 401(k) and/or receives other stock-related benefits such as restricted stock or company stock options,” Stewart says.

Caution and education are the name of the game when using ESPPs. “Before getting involved in an employee stock purchase plan be sure to read all the rules and guidelines just as you would before you invested your money in anything else,” Simpson says. “Make sure you know if the company’s stock trades on the stock market or over the counter via pink sheets. Make sure you know what fees are involved in the process and how they are calculated.”

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What Are ESPPs? originally appeared on usnews.com

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