A Beginner’s Guide to Employee Share Plans
So you’ve started a new job and the company is offering stock options as part of its benefit package. You may not understand what this means, or you may not know where to start. Here are some of the basics you should know.
Most companies offer benefits as part of a payroll package: vacation days, 401 (k) s and, in some cases, the option to invest in company stock. This is usually done in the form of an Employee Share Purchase Plan (ESPP) or an Employee Share Ownership Plan (ESOP).
The benefit is the same anyway: you make a profit when the company profits. Obviously, this has a downside: if the company doesn’t perform as well, your savings could plummet.
Ownership plans and purchase plans
With both ESPP and ESOP, you share in the company’s success.
Companies offer them as part of your benefit package, and while they can be solid benefits, your employer also uses them as a way to build employee loyalty.
And in some cases, they are offered in lieu of a higher payment. For example, start-up companies often offer these benefits because they may not be able to pay their employees the average wage.
Aside from the basics, the two plans are quite different; the main difference is how they are funded.
With ESOP, your employer buys stock for you. When your benefits start to take effect, these promotions will become yours. But you don’t have access to the money you earn from them until you retire or leave the company. In this respect, it is similar to the 401 (k) plan .
With ESPP, you contribute to the plan yourself through payroll deductions. This means that some of the money from your salary will be spent on buying shares in the company and saving in this plan. The good news is, you’ll get access to money sooner – you don’t have to wait for retirement.
Pros of buying employer stock
Obviously, ESOP is beneficial because the company is simply giving you free promotions. This is an inherent benefit for employees.
With ESPP, you pay with your money, but there are still benefits. First, many employers will offer a match. This means that for every dollar you invest in the plan, they will match you up to a certain percentage. They still give you free items, but with the caveat that you must buy them too. If the company succeeds, you can make a big profit given that some of the shares were free.
Plus, some employers even offer discounts on their promotions. This means that you can buy their shares for 15% less than they are traded on the market. This is a pretty good deal because when the stock rallies, you earn more than the average Joe who invested full value in your company.
What’s more, some plans include a retrospective analysis clause, which could result in even greater discounts. In hindsight, you are offered the stock at the lowest price during the offer period (the period during which you are allowed to buy the stock – more on that later).
Of course, the market fluctuates, as does the value of your company’s stock. But you still buy it cheaper.
Disadvantages of buying employer stock
One of the most important caveats about these options is that you don’t want to be over-invested in your company. Yes, returns can be tempting. But when there is potential for high rewards, there is almost always potential for risk. If the company is down, your income doesn’t really matter.
Diversification is the key to success
We’ve shown you how to build a robust buy-and-hold portfolio , and one of the most important steps is to stay diversified. It is unwise to invest too much in one asset. You want to invest in a wide variety of companies, markets, industries, and even financial instruments.
Even if your employer offers a discount, you don’t want to invest too much in your company’s stock. Yes, most experts recommend taking stock from this employer, if offered. But not through overinvestment.
Bottom line: you don’t want your entire income stream to depend on one company.
What contribution should you make?
As a general rule of thumb, don’t invest more than 10% of your portfolio in employer stock .
Even if your employer offers a match, you may not receive the full amount from them. It is much more important to invest your money wisely than to get a discount.
In addition, the closer you are to withdrawing your money, the less you will want to invest. Yahoo Finance offers to reduce the amount by up to 5% if you need money any time soon.
Examine your investment
When you invest so much in one company, you have a great responsibility for its health.
You will want to explore the company like any other investment. USA Today invites you to compare a company’s performance against competitors, read the latest company news and analyst reports. If there is news that your company may be acquired, you may consider selling those shares or you may look forward to a higher buyback offer. If the company is not doing so well, you may want to consider selling it before it bottom out.
There is, of course, a lot more to active investing, and some recommend that you stick with these situations. But it confirms the point: active investing is risky, so you want to limit how much you invest in employer stock.
Know when to sell
Another thing to keep in mind when planning your purchases: you don’t have to buy and hold. This is not a retirement plan. Once you have acquired the ownership (more on that in a minute), you can sell the shares.
Of course, if the stock price rises after you sell them, you can kick yourself. But don’t kick too hard, because you made a lot of profit anyway and freed up your portfolio for more diversification.
How vesting works
Either way, your company is likely to have a vesting period . This means that even if you can participate in the plan, you will not fully own all of your holdings until a certain amount of time has passed.
For example, in most ESOP plans, you do not have employment entitlements at all. After a year, you can get 20%. After six years, you can get all rights.
If you leave the company before you have all the ownership rights, you will only receive the percentage of the shares that you own at that time. The rest is returned to your employer.
With the ESPP plan, you are simply not allowed to sell your shares until you get the title.
How to enroll in your plan
With ESOP, you are usually automatically enrolled when you are hired. When you leave, you probably want to transfer your shares to your retirement account in the same way you did with a 401 (k) . But we’ll look at these options later.
With ESPP, registration is a bit tricky, but still pretty easy. There are a few useful terms to be aware of:
- Offer Date : The first day of the offer period your employer allows you to start contributing to the plan.
- Offer Period : The period of time during which you can save money from your paycheck to contribute to your plan.
- Purchase period : the period of time during which the shares of the company are actually purchased.
Investopedia explains that most offer periods include multiple purchase periods. Thus, a plan can have a three-year offer period with four purchase dates or periods.
Once you decide to participate in the plan, you sign up on the next available offer day. You fill out an application and indicate how much you want to deposit. Usually this amount is capped at about 10% of your salary after taxes. (The IRS also limits contributions to $ 25,000 per year.)
Once the offer period begins, money will be deducted from your paycheck until it is time to buy the stock on the day you buy it. Once that date is around, you will have an account that will track your purchase of the stock.
What to do when you leave the company
If you quit a job in which you had an ESOP, your employer has six years to begin distributing your benefits. At this point, you have several options: defer the distribution until retirement, move the distribution to the IRA, or cash out. If you cash out this amount, you will pay taxes on this amount and it will be taxed as regular income. If you cash out before retirement, you will also pay 10% “excise tax,” according to the National Employee Property Center .
ESPP contributions are made in dollars after tax. The money you used to buy the stock was already taxed, so the IRS doesn’t care when you cash out your ESPP. As long as you have all the rights, this money is liquid: you can withdraw it whenever you want.
Of course, if your company was profitable, you probably made a profit on your stock. This income is called capital gains and you will be taxed on it when you cash out. But with most ESPPs, you are taxed at a special “capital gains rate” that is likely lower than your income tax rate.
Each plan, be it ESOP or ESPP, also has its own individual cash out and benefit allocation rules, so you’ll always want to check your plan summary for more details.
Overall, employer stock plans are a big advantage, but one of the most important factors to keep in mind is diversification. You don’t want most of your home equity to be tied to your company. Monitoring is also important: even after you leave the company, you should keep a close eye on its performance if you are still investing in its stock.
Be sure to take advantage of this, but not to the point that it prevents you from having a healthy, diversified investment portfolio.
This post was originally published in 2015 and was updated on June 16, 2020 by Lisa Rowan. Updates include the following: revised accuracy links, updated formatting to reflect the current style, revised title and feature image, revised article to combine some of the content.