Making Sense of Employee Stock Purchase Plans (ESPPs)

Making Sense of Employee Stock Purchase Plans (ESPPs)

If you work for a publicly traded company that offers an Employee Stock Purchase Plan (ESPP), you could be in for a treat. A prerequisite before diving in is that your company’s stock is halal (permissible) to invest in; if it is, an ESPP can be quite a boon.(Note: You can check the halal stock reports right here on Practical Islamic Finance to see if your company is listed).

How does it work?

Suppose your company has an offering period of six months: January to June and July to December. You can enroll in the ESPP before an offering period begins and decide on what percentage of your paycheck you’d like withheld to eventually be used for the stock purchase. Bear in mind the Internal Revenue Service (IRS) currently allows a max contribution of $25,000 per year towards an ESPP1.

Continuing with our example, let’s say you enroll before the start of the new year and settle on a 10% contribution towards the ESPP. Your net pay will be 10% less throughout the duration of the offering period. Come July 1st, that sum of money that was withheld from your paychecks will be used to purchase company stock on your behalf. But here’s the kicker: the stock is purchased at the lower of the two stock prices at the beginning and end of the offering period (i.e. January 1st vs June 30th), typically with a 15% discount.

Let’s use some numbers to really put this into perspective. Suppose the stock price was $40 on January 1st and $50 on June 30th. Getting the stock at $40 would be a good deal, but you actually get it at $34 per share thanks to the 15% discount! If the stock price remains at $50 on July 1st, you could turn around and sell your newly acquired shares for a profit of $16 per share, which translates to a 47% gain.

Big caveat, though: There’s a capital gains tax any time you sell stocks at a profit, and the tax rate is considerably higher if you sell in less than a year of holding those stocks. That can really eat into your gains. I would recommend using an online calculator to play around with the numbers before making a sell vs. hold decision.

Why do companies offer ESPPs?

It’s generally a win-win. Companies are able to hold onto cash longer, which can be used for other purposes. Employees are incentivized to perform well and help the company succeed, as they (along with all shareholders) will benefit from a higher stock price. It can also build loyalty, improve employee retention, and attract new talent.

What’s the catch?

Not everyone’s a fan of ESPPs. Finance guru Dave Ramsey advises his listeners against it2. The risk is that you’re putting a lot of eggs into one basket. Getting a tumbling stock at a discount is only a good deal if you’re able to get out before the stock falls even further.

Additionally, suppose the company isn’t doing too well, lays off employees and you get the cut. Now you’re out of a job and the stock you’re heavily invested in is doing poorly.

You’ll have to analyze the stock just like any other stock you’d invest in. On a positive note, you work for the company and should have a decent idea of how the company’s doing. However, if you’re financially stable, have emergency savings set aside, and can afford to invest a portion of your paycheck, ESPPs are definitely worth considering. Just be cognizant of the risks like you would with any other investment.

Disclaimer: Not meant as personalized investment advice.



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