At TCI, we’re big believers in helping clients make the most of the opportunities available to them, especially when it comes to employer benefits. One of the most underutilized and often misunderstood tools in equity compensation is the Employee Stock Purchase Plan (ESPP).
Whether you’ve just started a new job at a publicly traded company or you’ve been enrolled in your company’s ESPP for years, this guide will help you understand how these plans work, why they matter and how they can fit into your broader financial life.
What Is an ESPP?
An ESPP allows eligible employees to purchase shares of their company’s stock, usually at a discount, through payroll deductions. Unlike restricted stock units (RSUs) or stock options, which are granted by the company and often tied to performance or tenure, ESPPs are elective. You choose whether to participate and how much of your paycheck to contribute.
Participating in an ESPP isn’t just about chasing returns. If integrated well into your overall wealth strategy, ESPPs can serve as a powerful wealth creation opportunity. Done passively, it can quietly lead to unintended concentration and tax complications. This is why understanding how ESPPs work, and how they fit into your financial plan, is essential.
How Do ESPPs Work?
At a high level, here is how a typical ESPP functions:
- Enrollment Period: You elect to participate and choose what percentage of your paycheck (up to the plan’s limit) you want to contribute.
- Offering Period: This is the duration in which contributions are deducted from your paycheck and purchases occur, typically 12 or 24 months.
- Offering Date: The date that the offering period begins. This is an important date if your plan includes a “look-back” provision, as the stock price on this day will help determine what your eventual purchase price will be.
- Purchase Date: At set intervals, often every six months, your company uses your accumulated payroll deductions to purchase stock.
- Purchase Price: This is the price you pay per share when stock is purchased on your behalf. It’s typically calculated as the market price on the purchase date, or the offering date, if your plan includes a lookback provision, minus the plan’s discount (commonly up to 15%). For example, if your company’s stock is trading at $50 and your discount is 15%, your purchase price would be $42.50.
- Lookback Provision: If your plan includes this feature, the discount is applied to the lower of the stock price on the offering date or purchase date. This can meaningfully boost your return.
All contributions are deducted from your gross pay, before taxes, insurance, or other withholdings. You can lower or pause your contribution mid-cycle, but most plans don’t allow you to increase it during the offering period. After shares are purchased, they’re deposited into your account. From there, you can hold or sell, depending on your goals and any trading restrictions you may be subject to.
Qualified vs. Non-Qualified ESPPs
Most people are only familiar with qualified ESPPs, but there are actually two types: qualified and non-qualified plans. While they operate similarly on the surface, the key differences come down to tax treatment and regulatory structure.
Qualified ESPPs (Section 423 Plans)
These are the most common and follow rules laid out under IRS Section 423. To qualify:
- The discount cannot exceed 15%.
- All employees with two years of service or less must be eligible to participate.
- The plan must be approved by shareholders.
- Employees cannot purchase more than $25,000 worth of stock per year (based on the stock’s undiscounted fair market value).
- There are favorable tax treatments if you hold the shares for at least two years from the offering date and one year from the purchase date.
If you meet those holding requirements, a portion of the gain can be taxed as long-term capital gains instead of ordinary income, which can be a big advantage.
Non-Qualified ESPPs
Non-qualified ESPPs don’t follow Section 423 and aren’t bound by the same rules. This offers more flexibility for participants. For example, a company could offer different discounts to different employees or extend eligibility to international staff. But this flexibility comes at a cost: there are no favorable tax benefits, and any discount you receive is treated as immediate taxable income.
Due to this, non-qualified plans are rare, especially among U.S.-based companies. Most prefer to stick with the standardized structure and tax efficiency of a qualified plan. If you do encounter a non-qualified ESPP, it’s even more important to understand how the income is reported, how it affects your tax bill, and whether participation still makes sense in your situation.
Why Participate in an ESPP?
There are a few good reasons to consider enrolling:
- Built-In Discount: Purchasing stock at a 5% -15% discount effectively gives you a pre-tax return on day one.
- Compounding Gains: If your company’s stock rises after purchase, those gains are added to your initial discount.
- Flexibility: You can often sell the shares immediately after purchase or hold them for long-term tax benefits.
- Tax-Efficient Planning: When integrated thoughtfully, ESPPs can play a meaningful role in your overall tax strategy, especially when coordinated with other benefits like a 401(k) or HSA. Understanding when to sell, how long to hold, and how it fits into your income picture can help you avoid surprises and make the most of what your employer offers.
But ESPPs also require careful attention. Too often, employees continue buying shares for years without selling, leading to concentrated positions in their employer’s stock. If the company does well, great. If not, a large portion of their wealth is exposed to a single asset, and one that’s already tied to their income.
How the ESPP Lookback Provision Boosts Your Return
One of the most powerful features in some ESPPs is the lookback provision. It allows the plan to “look back” to the offering date and apply your discount to the lower of the two prices, offering date or purchase date.
Example:
- Offering date price: $30
- Purchase date price: $50
- You get a 15% discount on $30, meaning you buy at $25.50 while the market value is $50.
That’s an instant 96% gain, pre-tax.
Plans that include this feature, especially those with longer offering periods, can provide tremendous upside. Some companies even have an automatic reset built in, which adjusts your offering window if stock prices drop, letting you take advantage of the lower price in future purchase periods.
What Happens If You Leave Your Company?
If you leave your company mid-offering, any accumulated contributions that haven’t yet been used to purchase stock are refunded to you. If you already own ESPP shares, those shares are yours. The company doesn’t reclaim them when you leave.
What Happens After You Buy ESPP Shares?
Once shares are purchased, they’re typically deposited into a brokerage account tied to the ESPP. From there, you can:
- Sell immediately (disqualifying disposition)
- Hold for a year (and two years from offering date) to qualify for long-term capital gains (qualifying disposition)
- Most stock plans and companies require you to hold your ESPP shares in your stock plan account. This is due to the tax reporting requirements when shares are eventually sold.
The right move depends on your goals, your tax bracket, and how much exposure you already have to company stock. Sometimes it makes sense to hold for tax efficiency. Depending on how the stock price has moved since the offering date, selling right away and reallocating that cash elsewhere can be a better move.
There are two different types of tax treatment when it comes to your ESPP shares. A qualifying disposition and a disqualifying disposition. Knowing which one applies to your shares is very important for the manner in which your sale will be taxed. For a more detailed explanation of how the taxes on ESPP shares work, TCI will be publishing a follow up blog dedicated specially to this.
How ESPPs Fit Into Your Broader Financial Plan
On paper, ESPPs can seem straightforward: enroll, contribute, purchase stock, repeat. But in real life, your participation touches nearly every corner of your financial plan, from taxes and cash flow to investment risk and long-term goals.
That’s why we don’t look at ESPPs in isolation. At TCI, we consider how this benefit fits into the bigger picture:
- Does participating still allow you to fund your emergency savings or other short-term priorities?
- If you’re already contributing to a 401(k) and HSA, how much additional withholding can your paycheck absorb?
- How do taxes factor in if you decide to sell the shares right away—or wait to qualify for long-term gains?
- Are you gradually building up too much exposure to your company’s stock without realizing it?
- Does your company offer other powerful savings strategies like the Mega-Back Door?
These aren’t just tactical decisions, they are reflections of what you are working toward. For some clients, the goal might be to take advantage of short-term gains and fund a Roth IRA. For others, it may be reducing concentrated risk as they approach retirement. For many, it’s about finding the right balance between today’s opportunities and future flexibility.
There’s no one right answer, but there is the right approach for you. We help you weigh your options, prioritize your goals and bring clarity to what’s often a confusing benefit. In the end, your ESPP isn’t just a financial perk, it’s another tool to help support the life you’re building.
Making the Most of Your ESPP
ESPPs are a powerful way to build wealth, but they’re not automatic. Without a clear plan, you could find yourself with too much risk or unanticipated tax consequences. With the right strategy, though, ESPPs can unlock real opportunity.
That’s where we come in. If you’re navigating equity compensation and want to make sure every piece of your plan is working together, we’re here to help.
This material has been prepared for informational purposes only and is not intended to provide or to be relied upon as tax advice. TCI is neither a law firm, nor a certified public accounting firm, an no portion of its services should be construed as legal or accounting advice. No client or prospective client should assume that any information contained herein serves as the receipt of, or a substitute for, personalized advice from TCI, or from any other investment professional.
