If you work for a publicly-traded company, your employer may offer you the chance to buy shares of your company’s stock through a program called an Employee Stock Purchase Plan (ESPP). The idea behind ESPPs is simple – to give employees the opportunity to profit from the success of the firm and participate in its growth. The thought is that employees who are also owners will be better at their jobs and more dedicated to the company and its success.
Participating in an employee stock purchase plan can be a smart way to build your investment portfolio, and a good way to save for retirement. The key is to understand both the potential advantages and the possible pitfalls of these popular programs.
Understand Your ESPP Discount
One of the primary selling points of an employee stock purchase plan is the discount. Depending upon the plan design, you may be able to purchase shares at a discount of between 5 and 15 percent. A 15 percent discount means that shares currently trading for $50 on the open market could be yours for only $42.50, a significant savings that gives you a profit from day one.
Of course, there is no guarantee that the stock price will not go down after the shares are purchased, and it’s important for you to do your homework before participating in your company’s ESPP. The same research that goes into any stock purchase applies to these plans, and it’s important to assess the financial health and future prospects of the firm with an unbiased eye.
Know When You Can Sell Your ESPP Shares
It’s important to thoroughly read the fine print before signing up for an ESPP. Some firms impose special rules and blackout periods on sales of shares by employees, especially those who may have inside knowledge of the company.
This could mean restrictions on when you can sell your shares which could have an impact on any future profits. Be sure to find out when you can sell your shares and how many shares you can sell.
Understanding all the ins and outs of the program before you get started is essential.
Forced Savings in Your ESPP Can Be a Good Thing
One of the advantages of an employee stock purchase plan is that it forces you to save and invest. Forced savings can be useful to help instill the kind of discipline needed to build a large portfolio over time. Simply learning to live on less than you make can be a powerful lesson, and one that can be extended to other investments like mutual funds, ETFs and 401(k) plans.
Since the money comes right off the top of your paycheck, you never see it – or get a chance to spend it. In the financial world this is known as the pay yourself first strategy, and it can be remarkably effective at building wealth.
Avoid Single Stock Concentration in Your Investment Portfolios
One of the dangers of participating in an employee stock purchase plan is that it could lead to too much concentration in a single stock. It can be tempting to load up on company stock, especially if the shares are offered at a deep discount and you have enough free cash flow to make the investment.
It’s important to keep in mind, however, that putting too much of your money in any one stock can be risky. Keeping your investment in the company you work for to no more than 4-5 percent of your overall stock portfolio is one way to mitigate that risk without giving up the potential for a healthy profit.
It’s a good idea to examine your portfolio at least a couple of times a year, looking at not only your company stock in your ESPP but other stocks and mutual funds you own. If you find that your portfolio is overweight in your company stock, you can sell those shares and rebalance into other areas.
ESPP Tax Considerations
When you do sell your shares, hopefully you will do so at a profit. After all, that is the whole idea behind employee stock purchase programs – to give ordinary employees a chance to profit from the success of the firm.
That profit comes with a price, however, and it’s important to be prepared. If you sold your company stock for more than you paid, you will have to pay capital gains taxes on the profit. The percentage of that tax will depend on a number of factors, including how long you held the shares and your level of household income.
It is always a good idea to talk with your financial advisor or accountant about the tax implications of selling company stock, especially if you’re considered a highly compensated employee.
An ESPP should not be your only investment, and it is important to diversify your holdings. But if your employer offers such a plan, it is definitely worth your consideration. As a conscientious employee, you are already dedicated to the success of the company. Taking advantage of an employee stock purchase plan allows you to profit from your dedication.
Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. Before making major financial decisions, please speak with us or another qualified professional for guidance. The original version of this article first appeared on Wealthtender written by Brian Thorp.