Many companies within the tech industry offer access to an Employee Stock Purchase Plan (ESPP). These plans are often overlooked because they do not offer tax benefits like pre-tax 401(k) or Deferred Compensation contributions. However, if you are not participating in your company’s ESPP, here’s what you may be missing out on.

What is an ESPP?

What is common across ESPPs is that you are allowed to defer salary for a specified period of time in order to purchase shares of company stock at a discount to Fair Market Value. This discount is often 10% or 15%, but that varies (as does the amount you can contribute.) The IRS allows up to 15% of salary or $25,000, whichever is lower, to be directed to ESPP; however, your company may limit you further.

An Example of an ESPP: Microsoft

Despite the lack of up-front tax benefits, many ESPPs are a no-brainer if you can facilitate the cash flow disruption. However, ESPPs vary significantly across companies, so please consult with a fiduciary financial advisor to review your specific plan before enrolling.

Take the Microsoft Employee Benefits offering as an example. Microsoft employees who do not qualify to contribute to the Deferred Compensation plan should consider participating in the program. At Microsoft, you can defer up to 15% of your salary and let the cash build up during the course of each calendar quarter. At the end of the quarter, these funds purchase shares of MSFT at a 10% discount to Fair Market Value.

If you sell these shares immediately in the open market, you will see ~10% increase in value. The 10% discount will be treated as taxable income to you, but even if you are in the highest marginal Federal tax bracket (37%) you will realize an immediate 6.3% after-tax return on investment.

The Difference an ESPP Makes

If you work at Microsoft and decided to defer $500 per paycheck into the ESPP, you would see $500 added into your Fidelity account each paycheck and held in cash until the end of the quarter. At the end of the quarter, you would have $3,000 to purchase MSFT stock. No matter what the price of MSFT does during the quarter, you will purchase $3,000 worth of shares for 90% of Fair Market Value. If MSFT shares were trading at $100 / share in the open market, you would buy at $90 / share.

You would end up purchasing 33.33 shares (partial shares are often allowed within ESPP) for $3,000. After the purchase, these shares would be worth $3,333.00 in the open market. It is important to be mindful of company blackout periods, but oftentimes ESPP purchases will occur during an open window to buy and sell shares. Therefore, you could immediately sell your shares and realize a gain of $333 each quarter. This would be taxable to you, but essentially generates “free” money to you.

Diversification and ESPPs

With the Microsoft ESPP as well as many others, you are not exposed to the price fluctuations of the underlying stock during the deferral period because you get a discount at the time of purchase. Many other plans do expose you to fluctuations of the underlying stock price during the deferral period, in which case it may not be as beneficial for you to participate.

We typically recommend to our clients that they should minimize their exposure to the stock price of their company. Allocating too much of your financial capital and your future income to the same company can be a very large (and often unnecessary) risk.

We recommend that our clients diversify their financial capital away from their company as much as possible. That being said, it is still possible that the benefits offered by your ESPP outweigh the downside. To figure out the proper diversification strategy, we suggest that you consult with a financial professional.

What to Do Before You Invest In an ESPP

Before signing up to participate, be sure to understand how your ESPP plan works and whether it makes sense for your unique situation. If you have questions, please reach out to us. We can help you understand how your plan works.

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This article is for illustrative purposes only. Individual situations may vary. Please consult your tax advisor to determine if the scenarios discussed in this article are right for you. Investment Advisory services offered through Avier Wealth Advisors. Avier is not affiliated with Microsoft.