What Is an Employee Stock Purchase Program (ESPP)?
An employee stock purchase plan is a program that permits employees to use some of their paycheck to buy stock in the company for which they work at a discount. Such plans often are presented as an extra benefit and are used for employee recruitment and retention purposes.
Purchasing Shares Under a Plan
If your employer offers an ESPP, you participate by telling your employer to put some of your paycheck toward buying shares of the company. Then, when you get paid, part of your salary is used to purchase shares instead of being paid to you directly. For example, say your employer offers a 10 percent discount and lets you elect to put up to 10 percent of your salary toward purchasing shares. If your monthly salary is $4,000, you could use up to $400 per month to buy stock at a discount.
Besides the discount, employees also benefit if the plan offers a look-back period. This feature allows the employee to base the purchase price on the lowest offered price during the look-back period, typically three to six months, according to Bankrate.com. For example, say your company's plan offers a three-month, look-back period. If the current price of the stock is $50 per share, but at one point in the last three months it was $40 per share, you base your purchase price on $40.
Besides the obvious advantage of getting stocks at a discount, ESPPs also offer the advantage of being liquid assets, which means you can easily convert them to cash. All you have to do is sell your shares when you need the money. If, on the other hand, you put money in a 401(k) plan, you usually would pay a 10 percent early withdrawal penalty if you cashed out your money before turning age 59 1/2.
Qualified Versus Nonquaified Plans
Most employee stock purchase programs are qualified plans, which means you don't have to pay taxes on the value of the discount until you sell your shares. For example, say you buy $1,000 of stock but only pay $850 because of the discount your employer offers. In a qualified plan, you won't pay taxes on the gains over $850 until you sell your shares. But, if your employer offers a nonqualified plan, you owe taxes on that $150 immediately. With a qualified plan, you're limited to purchasing $25,000 in shares per year. This limit doesn't apply to nonqualified plans.