A Beginner’s Guide to Your Company’s Employee Stock Plans

Kristin Wong, Contributor, Lifehacker

October 17, 2016

A Beginner’s Guide to Your Company’s Employee Stock Plans

So you’ve started a new job, and the company offers stock options as part of their benefits package. Maybe you have no idea what that means, or you’re not quite sure how to get started. Here are some basics you should know.

Most companies offer perks as part of a salary package: vacation days, 401(k)s, and, in some cases, the option to invest in company stock. Usually, this is in the form of an Employee Stock Purchase Plan (ESPP) or an Employee Stock Ownership Plan (ESOP). With either one, the benefit is the same: you profit when the company profits. Obviously, the flip side of that is: if the company doesn’t do so well, your savings can plummet.

Ownership Plans vs. Purchase Plans

With both an ESPP and an ESOP, you share in the company’s success. Companies offer these as part of your benefits package, and while they can be a solid benefit, your employer also uses them as a way to foster employee loyalty. And in some cases, they’re offered in lieu of higher pay. For example, startup companies often offer these benefits because they may not be able to pay workers an average salary.

Beyond the basics, these two plans are pretty different, and the main difference is how they’re funded.

With an ESOP, your employer buys stock for you. When your benefits kick in, those stocks are yours. But you don’t have access to the money earned from them until you retire or leave the company. In this way, it’s similar to a 401(k) plan.

With an ESPP, you contribute to the plan yourself through payroll deductions. This means part of the money from your paycheck will be taken out to buy company stock and save in that plan. The good news is you’ll have access to the money sooner. You don’t have to wait until you retire.

The Pros of Buying Employer Stock

Obviously, an ESOP is beneficial because the company is just giving you free stock. It’s an inherent employee benefit.

With an ESPP, you’re paying with your own money, but there are still benefits. For one, many employers will offer a match. Meaning, for every dollar you invest in the plan, they’ll match you up to a certain percent. That means they’re still giving you free stock, just with a caveat that you have to buy in too. If the company does well, you could earn a big return, considering that some of the stock was free.

Plus, some employers even offer discounts on their stock. This means you can buy their stock for as much as 15 percent less than it’s trading on the market. That’s a pretty good deal, because when the stock grows, you’ve earned more than a regular Joe who invested in your company at full price.

Even better, some plans include a lookback provision, which could mean an even bigger discount. With a lookback, you’re offered the stock at its lowest price during the offering period (the period that you’re allowed to buy the stock; more on that later).

Investing site Fairmark offers an example:

At a company that maintains an ESPP with a 15 percent discount and a lookback provision, you might decide to contribute $850 during an offering period. At today’s price, that will buy $1,000 worth of stock. But if the stock goes up 20 percent during the offering period, the lookback provision lets you buy at the original price, and now you’ll be getting $1,200 worth of stock for the same $850 cost.

Without the lookback, you’d still have $1,000 worth of stock that you only paid $850 for. That’s an awesome deal. But with the lookback, you’ve basically earned an extra $200 worth of stock for the same price. Of course, the market fluctuates, and so will the value of your company’s stock. But you’re still buying it for less.

The Drawbacks of Buying Employer Stock

One of the most important caveats about these options: you don’t want to be overinvested in your company. Yes, the returns can be tempting. But when there’s a potential for high reward, there’s almost always a potential for risk. If the company tanks, your returns don’t really matter.

Diversification is Key

One of the most important steps to building a solid “buy and hold” portfolio is staying diversified. It’s not smart to invest too much in a single asset. You want to be invested in a variety of companies, markets, industries, and even financial vehicles. Even if your employer offers a discount, you don’t want to have too much invested in your company stock. Yes, most experts recommend taking that employer stock match, if offered. But not at the expense of overinvesting.

USA Today makes another interesting point about this. Even without buying any of your company’s stock, you’re kind of already invested in them:

Your day-to-day financial security depends on your company paycheck. If you have a pension, then part of your retirement is already tied up in your company. “You have so much on the line just by working at the place,” says Chuck Carlson, CEO of Horizon Investment Services, a Hammond, Ind., investment company.

The bottom line: you don’t want your entire income stream to be dependent on a single company.

How Much Should You Contribute?

As a general rule of thumb: don’t invest more than 10 percent of your portfolio in your employer stock. Keep that rule in mind when you’re crunching the numbers to decide how much to contribute. Even if your employer offers a match, you might not take them up on the full amount, because its more important to invest your money wisely than it is to get that discount. Of course, if you can afford to max out that benefit and invest in other assets, that’s ideal.

Also, the closer you are to withdrawing the money, the less you’ll want to have invested. Yahoo Finance suggests reducing the amount to five percent if you need your money in the near future.

Research Your Investment

With that much invested in a single company, you have a greater responsibility to monitor its health.

You’ll want to research the company like you would any other investment. USA Today suggests you compare the company’s return to competitors, read any recent news about the company and read reports from analysts. If there’s news that your company may be acquired, you might want to consider selling that stock, or you might hold out for a higher buy-out offer. If the company isn’t doing so well, you might consider selling before it hits rock bottom.

Of course, there’s a lot more that goes into active investing, and some would recommend you hold in those situations. But this kind of proves the point: active investing is risky, which is why you want to limit how much you’re invested in employer stock.

Know When to Sell

Another thing to keep in mind with a purchase plan: you don’t have to buy and hold. It’s not a retirement plan. Once you’re vested (more on that in a bit), the stock is yours to sell. Here’s what investing expert Allan Roth suggests, via Mint:

“Assuming the ESPP allows a significant discount, I recommend taking it,” he says. But with a caveat: he recommends selling the stock as soon as possible.

So here’s what I wanted to tell Amber: Sure, participate in the ESPP. Like a 401(k) match, it’s free money.

As soon as the offering period is over and you buy the stock, however, sell it the same day. You make an instant 17.6 percent return (the opposite of a 15 percent discount), and the risk is nearly zero.

Of course, if the stock price goes up after you sell, you might be kicking yourself. But don’t kick too hard, because you still nabbed a big return, and your portfolio is freed up for more diversification.

How Vesting Works

With either option, your company probably has a vesting period. This means, even though you can participate in the plan, you don’t completely own all the stock until a certain amount of time has passed.

For example, with most ESOP plans, you’re not vested at all when you’re first hired. After a year, you might be vested at 20 percent. After six years, you might be fully vested. If you leave the company before you’re fully vested, you only get the percentage of stock that you’re vested in at that time. The rest goes back to your employer. With an ESPP plan, you’re simply not allowed to sell your stock until you’re vested.

How to Enroll in Your Plan

With an ESOP, you’re usually automatically enrolled when you’re hired. When you quit, you’ll probably want to roll over your shares into a retirement account, the same way you would with a 401(k). But we’ll get into those options later.

With an ESPP, enrollment is a little more complicated, but it’s still pretty easy. There are a few useful terms to know:

  • Offering date: The first day of the offering period, when your employer allows you to start contributing to the plan.
  • Offering period: The time frame you’re allowed to set aside money from your paychecks to be contributed to your plan.
  • Purchase period: A time frame the company stock is actually purchased.

Investopedia explains that most offering periods include several purchasing periods. So a plan might have a three year offering period with four purchase dates or periods. Money Crashers offers another real world example:

For example, an offering period could start with an offering date of January 1 and then have nine purchase periods that last for three months each. The offering period would then expire at the end of 27 months. During that time, employees would elect to have a certain amount taken out of their paychecks — which would then be used to purchase company shares on every purchase date within the offering period. Therefore, employees who participated in an entire offering period would make nine separate purchases of stock.

Once you’ve decided to participate in the plan, you’ll enroll at the next available offering date. You’ll fill out an application and indicate how much you want to contribute. Usually, this amount is limited to about 10 percent of your after-tax pay. (The IRS also limits contributions to $25,000 per year.) Once the offering period begins, money will be deducted from your paycheck until it’s time to buy the stock on its purchase date. Once that date hits, you’ll have an account that includes your stock purchase.

What to Do When You Leave the Company

When you quit your job and you have an ESOP, your employer has six years to start distributing your benefits. At that point, you have a few options: defer distributions until you retire, roll over the distributions into an IRA or cash out. If you cash out, you’ll pay taxes on this amount, and it’s taxed as ordinary income. If you cash out before you retire, you’ll also pay a 10 percent “excise tax,” according to the National Center for Employee Ownership.

ESPP contributions are made with after-tax dollars. So the money you’ve used to buy the stock has already been taxed. Thus, the IRS doesn’t care when you cash out your ESPP. As long as you’re fully vested, that money is liquid: you can take it out whenever you want. Of course, if your company has been profitable, you’ve probably earned a return on your stock. This return is called a capital gain, and you will pay taxes on that when you cash out. But with most ESPPs, you’re taxed at a special “capital gains rate,” which is probably lower than your income tax rate. Nonqualified ESPPs don’t have this benefit, but they’re not as common. 

Each plan, whether it’s an ESOP or ESPP, also has its own individual rules for cashing out and distributing benefits, so you always want to check your plan’s summary for more detail.

Overall, employer stock plans are a great benefit. But one of the most important factors to keep in mind is diversification. You don’t want the majority of your net worth tied up in your company. Monitoring is also important; even after you leave a company, you want to pay close attention to its performance if you’re still invested in its stock.

By all means, take advantage of this benefit, but not to the point that it keeps you from having a healthy, diversified investment portfolio.

 

This article was written by Kristin Wong from Lifehacker and was legally licensed through the NewsCred publisher network.

All analyses and projections depicted herein are for illustration only, and are not intended to be representations of performance or expected results. The results achieved by individual clients will vary and will depend on a number of factors including prevailing dividend yields, market liquidity, interest rate levels, market volatilities and the client's expressed return and risk parameters at the time the service is initiated and during the term. Past performance is not a guarantee of future results.

Investors should seek financial advice regarding the appropriateness of investing in any securities, other investment or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. 

Although information in this article has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness, and it should not be relied upon as such. 

The strategies mentioned in this article may often have tax and legal consequences; therefore, it is important to bear in mind that First Republic does not provide tax or legal advice. Investors' tax and legal affairs are their own responsibility and readers should consult their own attorneys or other tax advisors in order to understand the tax and legal consequences of any strategies mentioned in this article.

The views of the author of this article do not necessarily represent the views of First Republic Bank.