Personal Finance

Employee stock purchase plans can carry 'a big risk,' says advisor. What to know before buying in

Key Points
  • If you’re working for a public company, you may have a chance to buy discounted shares through an employee stock purchase plan, or ESPP.
  • But before enrolling, you'll need to know all the rules and consider the risks, experts say.
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Are you willing to invest in your employer's stock at a discount?

If you're working for a publicly traded company, you may have a chance through an employee stock purchase plan, or ESPP.

Nearly three-quarters of public companies offered an ESPP in 2018, according to a Deloitte survey. Workers often use these to boost retirement savings: Those who participate in both a 401(k) and ESPP contribute 32% more to their 401(k) than employees investing in only a 401(k), a 2020 Fidelity report found.

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But experts say there's a lot to consider before opting in.

"Any time you're investing in single company, there's certainly a big risk," said certified financial planner Kristin McKenna, managing director at Darrow Wealth Management in Boston.

How employee stock purchase plans works

Typically offered to all employees, ESPPs may allow you to purchase company stock at a discount of up to 15%, capped at $25,000 per year for tax-qualified plans.

The plan collects after-tax contributions from each paycheck during an "offering period," and uses the funds to buy company stock on a specific date.

"The gold standard for a plan is going to be a 15% discount with a lookback feature," said Bruce Brumberg, editor-in-chief and co-founder of myStockOptions.com.

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A lookback provision bases the stock purchase price on the value at the beginning or end of the offering period, whichever is lower. For example, let's say your ESPP offers a 15% discount and a lookback. With a $20 starting price and $22 ending price, you'll lock in a 15% discount on $20, for total savings of $5 per share (a 22.7% discount off the current market price). 

Nearly 4 in 10 public companies offer discounts and lookbacks for ESPPs, according to a 2022 report from Morgan Stanley at Work.

What to know before selling your shares

While it may be tempting to cash in your discounted shares, there are complicated tax rules to consider, including levies on the discount. The breakdown of regular income and more favorable long-term capital gains depends on when you sell.

Your employer may also require you to keep the shares for a set period of time. "Some companies have an additional holding period requirement," Brumberg said. "They don't want you to flip the shares."

The gold standard for a plan is going to be a 15% discount with a lookback feature.
Bruce Brumberg
Editor-in-chief and co-founder of myStockOptions.com

Of course, there are other key details to confirm in the plan document.

You'll want to know whether the ESPP is tax-qualified, which may offer savings, as well as how to enroll, the length of the offering period, purchase dates, how to make changes and what happens if you pull out of the plan, he said. 

Check 'all the other boxes' before an ESPP

While a down market may offer an even deeper discount, allowing you to buy more shares, there are other trade-offs to consider before piling in. 

There's no guarantee you'll make a profit, because "stocks don't always go up," McKenna said.

Indeed, most individual stocks don't outperform the market, according to a J.P. Morgan analysis. From 1980 to 2020, nearly 45% of companies from the Russell 3000 Index suffered a 70% price decline from peak and never recovered, the report shows.

Given these risks, experts may suggest an ESPP to compliment your 401(k), rather than as the primary way to save and invest. And you'll still want to weigh your risk tolerance and goals before enrolling.

An ESPP may be worth considering if you're already meeting your other financial goals, such as maxing out your 401(k), investing in a brokerage account, paying off debt or other savings goals, McKenna said.

It may work once you've "checked all the other boxes," she said, but it may be better to focus on other planning opportunities first.