It is the time for ESPP

Recently I’ve already written about one financial mistake I’ve made. Today I would like to talk about another one.

Another mistake

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

Russian Captain Obvious is watching you

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:

  1. 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.
  2. 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.
  3. 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).
  4. 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.
  5. 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.

Why 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*

ESPP and KGB IRS

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.

Conclusion

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.

boosh meme

I love this guy 🙂

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

Another Good ESPP Reads

* You can find about how to calculate effective annualized rate of return here

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11 Responses to It is the time for ESPP

  1. Good idea, Russian! It’s usually a good idea to take free money offered by your employer. As much as Dave Ramsey’s plan has helped us get out of debt, I don’t think we should follow everything he says.
    Mrs. Picky Pincher recently posted…Why Bottled Water Pisses Me OffMy Profile

  2. Brian says:

    We’re Ramsey fans too, but don’t follow everything he says. He’s a great starting point when you are finding your way out of debt, but everyone’s personal situation is different. Good luck with the ESPP! Sounds like a nice free money wealth building tool.
    Brian recently posted…Net Worth Update: June 2017My Profile

  3. The biggest risk with ESPP is liquidity. If you need it the cash is locked up. The second is the minuscule risk that the stock could tank from the time it was purchased till the time when it posts to your account to be sellable (usually a day or two). Those are not strong reasons to avoid participation as if done right those are small risks. Few public companies tank 15 percent in a day or two. As for liquidity, once the first period is funded all future periods you can live off the initial payout while saving new money.
    FullTimeFinance recently posted…Millennial Early Retirement Increase is ConcerningMy Profile

    • I agree with the second reason, the stock could go down in one day and it has happened in the history already. But if we speak of liquidity… If you really need the cash you can cancel your ESPP participation any time and get all the money in the next paycheck.

      But why would you do that? For this kind of situations people should have a strong emergency fund

  4. I think it makes sense to do. Especially if you’re maxing out your other tax-advantaged spaces. The 401K matching should take precedence first though, up to the employer’s max level of matching contribution. But all in all, a 10-15% discount on a healthy company’s stock, is not bad. I wouldn’t go all in on it though prior to the other shelters though. Only reason being, all your risk is concentrated in one company, and it happens to be the same company you work at, so you’re doubling down on the risk side of things. I feel bad for those enron employees (the good ones) who had all their money tied up in their company stock, along with their take-home salaries. So they got hit with a double whammie.

    • That’s a good point Tim.
      People shouldn’t have any debt, and use tax-advangated spaces first, at least up to the match.
      ESPP isn’t tax shelter investing by any means. It’s a usual stock investing but with 2 major differences:
      1) You get a discount
      2) It’s better for you to sell the same day you get the stocks.

      I don’t believe in single stock investment, that’s why I sell all my RSUs as well.

  5. I ignored my ESPP opportunity for a year or two but started contributing last year. I’m pretty close to maxing out ($25k per year) and get a 15% discount.

    Our plan purchases the shares at the end of the quarter, using the stock price at the end of the quarter. One small annoyance for me is that I need to get permission to sell my shares since I’m at a Director level. I’m usually granted permission within a few hours of my request and then I sell within a day or two of the purchase date.

    For us, it’s another low-risk tool in our overall savings and investing strategy.
    Mr. Need2Save recently posted…Ireland and England on $141 a DayMy Profile

  6. Kyle says:

    My Sister is able to do that, I know she takes advantage. Unfortunately(or fortunately) I’ve only worked for smaller engineering houses since college. No publicly traded employers. I like working close to home and slower paced work, but I try to keep my eyes open to new opportunities. More cash and benefits would be a welcome addition to building my wealth.
    Kyle recently posted…Losing 30 Pounds and Building WealthMy Profile

  7. J Savvy says:

    I joined a company with an ESPP late last year and just became qualified to contribute (takes 6 months of work to qualify). Hadn’t looked into it all that much yet, but I definitely will now!

    Good write up, Russian. Enjoyed this a lot.

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