Have you been offered equity compensation as a part of your benefits package in your company? Well then, congratulations! With this, you can now build towards financial wealth for yourself. Regardless of the level of compensation, it is highly crucial for you to see how your overall financial health would benefit, both short and long term.
Let us get a bit into this to understand whether you should buy employee stocks and when.
Employee Stock Purchase Plan
The employee stock purchase plan, also called ESPP, is a program run by the company in which employees can participate to buy company stock at a discounted price. It is easy for the employee to contribute to the plan with the help of payroll deductions, built up from the offering to the purchase date.
On the day of the purchase, the company uses the built up amount and purchases the stock of the company for the employee. For each employee stock purchase plan, the discount rate on the company shares is based on the particular plan. But it can go as much as 15% lower than the market price.
ESPPs can also have a “look back” provision, per the company’s agreement, that would allow the plan to utilize the historical closing price of the stock. This price may be either the price of the stock at the offering date or the purchase date, often whichever figure is lower.
There are two kinds of ESPP plans: qualified and non-qualified. All the participants in the qualified plan have the same rights and this plan needs the approval of the shareholders before implementation. The offering period in this plan can’t be longer than 3 years and there is a restriction on the maximum allowable discount on the price. On the other hand, non-qualified plans do not have as many restrictions as the qualified ones. But this plan does not have any tax advantages or after-tax deductions that the qualified plan has.
Further, ESPPs do not permit shareholders who own more than 5% of the company stock to participate in the program. There are also restrictions for employees who have not been employed with the company for a specific duration. The rest of the employees have the choice to participate in the program, but it is common for companies to allow only a few employees to participate.
Top things to consider before purchasing your employee stock
With this said, you now know the basics about the ESPP program that your company might be running to offer you shares. But does it mean that you are ready to purchase the shares from the plan? Here are some mistakes that you need to avoid before purchasing your employee stock purchase plan. These will help you know when is the right time to buy and what not to do.
1. Letting your Employee Stock Options Expire
The moment you are offered stock options, you have the chance to purchase a specific number of shares at a certain price, called the strike price. From here, you will also have a vesting schedule due to which you will have to stick with the company until all your shares are vested, which is a time frame from one to four years. And this means that you will have about 10 years to exercise your options. It is important that you take note of the company share price, in order to exercise your shares when the cost of the shares is higher than the strike price.
And as you see the price of the shares increase, you will be tempted to wait for a longer period of time before you exercise your shares. But as you do this, you will need to be aware of the expiration period. This is because as soon as the shares expire, they will be of no value to you. In fact, there are many stories where employees have missed their expiration date hoping to get more money on the table as the value of the stocks increase. And in the end, they lost everything. But then, when is the right time to exercise?
Well, here are some things that you can consider when choosing the time to exercise your stock options:
- What do you hope or expect to happen with the stock value between now and the expiration date?
- How much of your net worth do these stock options represent?
- Does your company have blackout periods when you won’t be able to sell or exercise the stock options?
- How will exercising the stock options change your tax situation? Would you be better off to exercise chunks of stock now, over several years or taking it all at once (essentially buying and selling the options at the same time)?
2. Ignoring the tax consequences of Incentive Stock Options
There are two kinds of options grants, ISOs (incentive stock options) and NSOs (non-qualified stock options). When ISO grants are received, there isn’t any instant taxation on it. But it is important that you pay attention to the value of the discount from your employer and the stock’s gain. This is because it can leave you subjected to the Alternative Minimum Tax (AMT).
In fact, when you eventually sell your shares, you will be subjected to pay the capital gains taxes on it. This means that the value of the shares you are selling has a higher value than the strike price. Normally, you will want to qualify for the long-term capital gains rates. For this, you will have to hold onto the shares for at least one year from the exercise date and two years from the grant date.
In case you sell the ISOs before the holding period, you will have to pay regular income tax on the difference between the FMV and the strike price of the shares. The income tax rate is much higher than that of the long-term capital gains rate. So, make the decision here smartly. But along with this, you should also account for the risk of the company stock you are holding and the percentage of your assets tied to a single stock.
3. Not knowing stock plan rules when you leave the company
Just so you know, if you leave the company before exercising your shares, the expiration dates go out of the window. So if you are planning to leave for any reason, it is important that you consider your stock options during the transition. As per many company stock rules, you will have about 60 to 90 days to exercise the vested stocks on exiting. This will limit your tax-saving strategies. Thus, plan your leave accordingly and ensure that you know all about the exiting rules and restrictions that come along with the exit.
4. Not Diversifying from your Company Stock
ISOs can be a huge part of your compensation package and the benefit can be great if you work for a company whose stock price keeps rising over the years. But even if you are working for a large company with a high stock price, you need to consider if you have a lot of your wealth tied up in a single stock. It is hard to sell your company stock, but it is something you need to consider.
There is a huge risk in putting all your investments into just one stock. This is because there is no guarantee that the company will always grow. Let us take a case where the stock value falls and eventually the company has to close. In such a case, you will lose all your investment. In fact, your risk increases as you are working for the company. Your savings and income all will come to a halt.
This is why you should also consider investing in other plans like a 401(k) and any others that are good for you. Diversify your investment savings and it will help you in the future. Take the help of a financial advisor so that you can have good future planning.
Once you have followed these tips, you will be able to figure out the right time to exercise your options and obtain all the benefits it has to offer. Just remember to keep a well-prepared and planned tax and investment strategy. To know more about the various taxes involved and other kinds of stock options, check out the knowledge-based articles here!