An employee stock purchase plan (ESPP) is a lucrative benefit that’s offered by some employers. If you’re fortunate to have access to an ESPP, you’re essentially being offered free money, and who doesn’t like free money right?
There’s no denying the financial benefit of an ESPP, but it’s not a guarantee. Stock prices can go up and down, so tying up all your money into your company may not be the best idea. However, if you plan things well with an ESPP, you can easily build your wealth. Here’s everything you need to know about employee stock purchase plans.
- What is an employee stock purchase plan?
- How employee stock purchase plans work
- ESPP vesting period
- What are the benefits of an employee stock purchase plan?
- How much should I put in an employee stock purchase plan?
- How are employee stock purchase plans taxed?
- How do you avoid tax on stock options?
- Can I transfer ESPP to my TFSA?
- Final thoughts
What is an employee stock purchase plan?
Let’s get the ESPP meaning out of the way. An employee stock purchase plan is a program that’s made available to employees by some employers. This plan allows you to buy stock in the company at a discounted price or you may get additional stock for free when purchasing shares through the program.
Since the program is managed by a third party company but endorsed by the company, you’ll usually get additional perks that aren’t usually available to the public. For example, you might be able to purchase fractional shares and you’ll have limited transaction fees.
You’re essentially allowed to buy company stock below market price which is a huge advantage for you. For example, let’s say your company gives you a 25% discount when purchasing shares through the ESPP. $100 in stock would cost you $75. That’s an instant return of 25%. It would be nearly impossible to beat that kind of return.
How employee stock purchase plans work
One of the major reasons why people are hesitant to join an ESPP is that the rules and options can be difficult to understand. Admittedly, if you have no understanding of how investing works, an ESPP can be overwhelming. Since every plan is different, you really need to understand how it all works. Generally speaking, there are three options when it comes to an ESPP:
In most cases, ESPPs are set up in some kind of matching format. This is where you as an employee can purchase company stock up to a certain percentage of your salary. Your employer, in turn, will match your purchase up to a certain amount.
For example, you might be allowed to purchase up to 10% of your salary in company stock as part of the ESPP. In return, your employer might match you by 10-50%. You’re essentially getting a raise with any contribution.
Another popular ESPP option is to allow employees to purchase company stock at a discount. e.g. 5-15% off the current market value. This is a bit easier to understand for most people since less math is involved.
Some plans might even offer a “look back option” that allows you to buy the stock based on the lowest price within a certain period of time. Let’s say you have a look back option that lasts for 90 days. In the last 60 days the stock has climbed an extra 10%. Your look back option would allow you to buy at the lower price.
Restricted Stock Unit (RSU)
Restricted stock units (RSU) are a bit more complicated since they have no value when granted. They’re typically issued to employees but the value only becomes real when you reach a certain timeline, which is known as the vesting period. Alternatively, sometimes the RSUs are granted when the company hits certain performance targets.
RSUs can be highly lucrative if the company grows. The cost to the employee is minimal, but you’ll need to stay with the company until your shares vest, or you’ll get nothing. It’s not uncommon for employees to quit right after their RSUs have vested.
Most companies that have an ESPP don’t give you a choice when it comes to the discount, matching, or restricted stock units. Sure, you can choose how much you contribute, but it’s not like you can choose the discount over matching. That said, companies that grant RSU may have different options available.
ESPP vesting period
Just about every employee stock purchase plan has some kind of vesting period built in to encourage employees to stay. There can also be multiple vesting periods which sounds silly at first, but makes sense when you understand them.
Generally speaking, vesting refers to the time before you actually own your shares outright. Let’s say your ESPP does stock matching. Any stock you purchase with your own money is owned by you right away. However, there’s likely a vesting period for the employer match which might be one year.
That means you don’t own that employer match until one year has passed. If you leave the company before that period, you may lose the match. Since most ESPPs buy on a monthly basis, it would operate on a first in, first out basis. The first shares you purchase/get matched, would get sold first if you decided to sell.
Although it’s not technically vesting, some companies may also increase the value of the ESPP the longer you stay. For example, you might get a 5% match after one year of service, 10% after two years, and 15% after three years.
Restricted Stock Units can have a much longer vesting period. As a new employee, you might be offered 1,000 shares with a price of $25 per share. That means your RSUs could be worth $25,000. However, the vesting period might be 200 shares at each anniversary. That means you’d have to stay five years for all your shares to fully vest.
Always read the rules about the vesting periods for your ESPP so you understand what happens to your shares if you ever leave the company. For RSUs, it’s often worth staying until your shares are fully vested.
What are the benefits of an employee stock purchase plan?
Okay, so you know what the ESPP meaning is, but you want to see how it applies specifically to you. I obviously don’t know your exact income or the details of your ESPP, but let’s use a general example so you can visualize the numbers. Let’s assume the following:
- Employee annual salary = $60,000 (gross)
- ESPP allows 1-10% (gross) in contributions
- Employer matches 25%
Admittedly, if you’re only contributing 1% of your income to your ESPP, you’re not going to walk away with much. That said, it’s still free money. If you’re able to max out your ESPP, that’s when the money really starts to roll in. Here’s a detailed look at the Rogers Employee Share Accumulation Plan to give you a better idea of how a specific plan works.
Remember, with matching or discounts, you’re always paying less than market price. You’re instantly ahead of someone who’s buying the same stock, but isn’t an employee. You can also benefit from any gains and dividends, so there’s potential to make even more money.
That said, there’s always the possibility that the stock price could go down. Since you’ve already received a match or discount right away, falling stock prices may not matter much. However, if you work in an industry that’s highly volatile such as cannabis, the drastic shifts in value can be quite the rollercoaster ride.
How much should I put in an employee stock purchase plan?
This is where things get complicated. Generally speaking, I advise people to max out their ESPP right away to get the most out of the benefit. However, I realize this isn’t possible for everyone, so there are a few guidelines I recommend.
Put in any amount to get the calendar rolling. Many ESPPs increase in value over time. It might take a few years before the full benefit kicks in. If money is tight right now, put in the minimum amount allowed so you can start building to the increased returns.
You may also want to consider using any extra funds you have available to your ESPP. Instead of focusing on your RRSP, TFSA, RESP, or mortgage repayments, consider maxing out your ESPP. The reason I suggest this is that your ESPP returns will usually be higher than any other account.
If you work in a volatile industry, contribute what you’re comfortable with, but don’t make it your only investment. As in, you may want to still contribute and invest in other things such as index funds instead of going all-in on your ESPP.
Regardless of what your strategy is, you should consider selling some of your ESPP every year after your vesting period ends. The money you get back can be used to top up the accounts you had originally diverted money from. This is a handy way to keep your portfolio diversified. The last thing you want is to have all your investments tied into your ESPP.
How are employee stock purchase plans taxed?
When selling your shares from your ESPP, you’ll usually have to pay a small withdrawal fee and possibly a fee per share as a brokerage commission. These fees are pretty common so don’t worry too much about them. What you do need to be concerned about are any gains you’ve made.
Since your ESPP is a taxable benefit, taxes would apply to the discount/matching in the corresponding tax year. Generally speaking, it’s like additional income, so you would have been given some kind of T slip. The numbers shown on that slip just get added to the relevant boxes when you file your taxes.
The bigger concern is any capital gains your shares have made. Capital gains would be the difference between the purchase price and the selling price. So if you originally bought the shares for $10 each, but they’re now worth $25. You have a capital gain of $15 each. Only 50% of capital gains are taxed. In this case, it would be $7.50 a share. Capital gains are added to your regular income, so the amount of tax you’ll actually pay is based on your marginal tax bracket.
In most cases, your employer will generate T slips for you that show your capital gains, dividends, and any relevant fees you’ve paid. This is handy since you just need to input the information when you file.
That said, sometimes, you may be required to track things on your own. This is a huge pain since you need to figure out the adjusted cost base (ACB) for the shares sold. I won’t bore you with the details, but essentially you need to log all the shares you’ve purchased through a site such as adjustedcostbase.ca. It’ll track everything for you. When you sell, put in the info, and it’ll tell you your capital gains. That’s what you report when you file your taxes.
For example, let’s say the shares cost you $10,000 when you bought them, but are worth $20,000 when you sell. That’s a capital gain of $10,000. Since you’re taxed on 50% of capital gains, $5,000 is added to your income. You’re then taxed at your marginal rate.
How do you avoid tax on stock options?
While no one enjoys paying taxes on stock options and ESPP sales, there’s not much you can do about it. Canada has a pretty fair tax system, so paying your share is just part of the deal when you live in the country. That said, there are a few ways you could reduce your taxes.
Make an RRSP contribution
Assuming you have the room available, contributing to your Registered Retirement Savings Plan (RRSP) is the best way to lower your taxes. For every dollar you put into your RRSP, you reduce your income by an equivalent amount. Let’s say you have $20,000 in capital gains that are taxable, but you contributed $20,000 to your RRSP. The amounts would cancel each other out so there would be no tax burden for the year. That said, RRSPs are taxed when you eventually withdraw from them.
Take a capital loss
If you have any other investments that are worth less than what you paid, you could sell them and realize your loss. This is considered a capital loss and can be used to offset any capital gains. Capital losses can’t be claimed on their own, so they’re beneficial if you’re claiming a capital gain.
Donate to charity
With the extra income, you could donate some of the money to a charity. This would give you a charitable donation tax credit. How much you’ll get depends on what province you live in and how much you’re donating. Since you’re donating the money to a charity, you’re not keeping any of it. The advantage here is to simply lower your tax bill. Most people who sell their ESPP would rather pay taxes than donate it.
Spread out your withdrawals
Every year you’re taxed on the amount of income you’ve earned. If you want to try and minimize your tax bill, you could spread out your withdrawals. For example, you could take out $10,000 every year instead of say $40,000 after four years. Essentially, you’re trying to avoid putting yourself into a higher tax bracket.
To be honest, I wouldn’t put much thought into trying to reduce your taxes. Yes, it’s important to keep your costs down, but the only real practical thing you can do is to contribute to your RRSP or to claim a capital loss. If you run out of room and you need to pay more taxes, don’t think of it as a bad thing. It just means you’ve earned more money. Remember, part of your ESPP is free money, you’re still coming out ahead.
Can I transfer ESPP to my TFSA?
Yes, you can transfer your stocks into your TFSA, but it may be a taxable event. First off, to get your stocks into your TFSA, you need to request a transfer. You need to have an account open at a discount brokerage to do this. You also need to have enough contribution room in your account for the year and overall. Some ESPPs may only allow you to transfer your ESPP without selling to the brokerage that they’re set up with.
When the transfer is made, there could be a capital gain even if you didn’t sell your shares since the move is a taxable event. If the value of your stocks has gone up from the time you purchase them, then you need to claim that capital gain. Once your shares are in your TFSA, future gains are tax-free.
An employee stock purchase plan is a great way to build wealth but it shouldn’t be the only thing in your portfolio. Max out your contributions if it makes sense for you and consider selling some of your shares every year to diversify. I personally used my ESPP as part of my downpayment and then later I used it to pay down my mortgage. Don’t delay, sign up for your ESPP now.