Recently I’ve already written about one financial mistake I’ve made. Today I would like to talk about another one.
A year after we came to the US I got a job offer from a company I always wanted to work for. It’s a publicly traded company that makes awesome products and has great benefits for employees.
One of the benefits that my employer provides is Employee Stock Purchase Program or ESPP.
This program allows you to buy your employer’s stocks with a discount (usually 10-15%).
There are some restrictions and nuances though that I will explain later.
I’ve been working for three years and haven’t participated in this program. Basically, I’ve been stepping over this “free” money.
At the beginning, we didn’t have enough extra money to buy stock because we were deeply in debt. Later, after we became debt free, we didn’t use this opportunity because I listen too much The Dave Ramsey Show where Dave always says that he doesn’t recommend people to use ESPP option.
Don’t get me wrong, I like Dave’s show. He’s helped more people than any of us, or all of us together. But his advice regarding ESPP is wrong and let me explain why.
How ESPP works
First thing first, you have to work for a publicly traded company. Second, your company has to share this benefit with you.
“Hey, Russian! You’re so smart and… obvious”
Usually ESPP deal works like this:
- You have to contribute to ESPP some money, usually it’s percentage from your paycheck. Most of the companies set 10% as maximum limit. The money is taken out from your paycheck up to the contribution limit. Your contribution is calculated on before tax money but taken after tax. There’s NO tax-deduction on this money.
- There are two purchase periods in a year, 6 months each. At the beginning of a period your employer will start withdrawing ESPP money from your paycheck. This money will be kept in a special account. You can end your ESPP participation any time and get your money back.
- At the end of a period all the ESPP money will be used for purchasing company stocks. It will be done automatically by your employer. Your get a discount on the purchase price. (usually the discount is 15%, but sometimes it could be less or more).
- Your employer takes to stock prices: at the beginning and at the end of a period. You get your discount on WHICHEVER IS LOWER price.
- You can sell this stocks right away without any restriction. Or you can hold them – it’s up to you.
Here’s a simple example.
Your bi-weekly paycheck is $2,542 before taxes. Your ESPP contribution is 10%. Every paycheck your employers will take $254.2 AFTER TAX money and set aside for six month.
After six month your ESPP account will have $254.2 * 13 (because of bi-weekly pay schedule) = $3,304.6
At the begging of this period your company stock price was $50, at the end of the period and went up to $72.00.
Your ESPP price will be WHICHEVER IS LOWER – 15%
In our example the price for you will be $50-15% = $42.5 for one share. And you can sell it immediately for $72/share
$3,304.6 / ($50-15%) = 77.755 (Stocks)
77.755 * 72 = $5,598.38
In this example your taxable profit is $5,598.38 – $3,304.6 = $2,293.78
What if the price went down?
It’s possible, and if you use ESPP long enough you will have this scenario as well. Let’s use this scenario as well. Let’s assume your salary and pay schedule are the same.
Price per share at the beginning – $32.00
Price per share at the end – $12.00
Remember, your ESPP price will be WHICHEVER IS LOWER – 15%
In this scenario the price went down, it’s bad but not for ESPP participants. In this case your price will be $12 – 15% = $10.2/share. You can sell it right away for $12/share
$3,304.6 / ($12-15%) = 323.98 (Stocks)
323.98 * 12 = $3,887.76
Your taxable profit will be $3,887.76 – $3,304.6 = $583.16
Of course, it’s less than in previous example but let me explain to you why you still need to bother.
I am going to use the worst example, when the price went down and your taxable return is $583.16 only.
This almost $600 seems to be not a big deal, but when you convert this money into percentage on your investment you will get completely different picture
$583.16 / $3,304.6 = 17.65%
Hold your horses, I am not done yet.
Because you didn’t put $3,304.6 at once, instead you contributed $254.2 every two weeks over the period of 6 month, your first contribution was tied up for 6 month, and the last one for a couple of days only. On average all your money ($3,304.6) was only tied up for 3 month.
What does it mean? It means that on average you earn more than 90% a year.
(1+17.65%) ^ 4 – 1 = 91.6%
More than 90% of risk free earning a year. RISK FREE and 90%, usually these two things don’t go together.
It’s time for you to take a cold shower, because 90% a year that’s when the price went down. You can calculate your earning when the price went up, the formula is easy:
(1 + (Profit / ESPP contribution * 100)) ^ 4 – 1 = RISK FREE ANNUAL EARNING*
Yes, you will have to pay some taxes, there’s no way to avoid that. And tax treatment for ESPP is different.
Unlike a Traditional 401(k), your contributions to the ESPP are taxed at ordinary income rates. If you hold your shares for more than a year after the purchase date AND more than two years after the beginning of the offering period then any profit above the gain from the discount will be taxed at capital gains tax rates.
But should you wait for two years to pay less taxes? I don’t think so, and nobody does. Because to save on taxes you have to hold these shares for another 18 months. Why would you do that if you have RISK FREE 90% return a year? Pay your taxes and don’t think about it twice.
You already earned a more than generous annualized return on the purchase. Holding on for another 18 months and hoping the stock won’t go down is stepping over dollars to pickup pennies.
Don’t get greedy. Paying taxes means you made money.
I’ve made a lot of mistakes already and, probably, will make some more. But every time when I find out about it I tend to learn the lesson and and adjust my behavior.
Foolish person is not the one who makes mistakes. Foolish person is the one who makes the same mistake more than once.
Fool me once, shame on you. Fool me twice – shame on me.
After Mrs. FR and I found out about the reality and power of ESPP we applied for it as soon as enrollment period started. What does it mean? It means we will receive smaller paychecks, which is great 😉
Algorithm is simple
- Make sure you have no consumer debt
- Contribute up to ESPP maximum
- Sell right after you get in possession of the stocks
Another Good ESPP Reads
- ESPP and Taxes by Turbortax
- Designing and Implementing a Section 423 ESPP by Timothy J. Sparks of Wilson Sonsini Goodrich & Rosati
- A Good ESPP is a No-Brainer by Wealthfront Knowledge Center
- Guide to Employee Stock Purchase Plans (ESPPs) by Kaye A. Thomas of Fairmark
- ESPP Is A Fantastic Deal by The Finance Buff
* You can find about how to calculate effective annualized rate of return here