Buying the stock at a discount gives you an instant return on your investment, but what should you do about selling it? To answer that question, you must consider two factors regarding selling ESPP shares: risk and taxes.
Risks of Holding Company Stock
Holding a lot of your wealth in a single stock is riskier than other investment approaches. On an investment risk scale of 1 to 5, with 5 representing the most risk, owning a single stock is a 5. You’re subject to industry risk, management risk, and event risk by holding a single stock. Even large, seemingly stable companies aren’t immune; for example, 57.73% of Enron employees’ 401(k) assets were invested in company stock as it fell 98.8% in value during 2001. Consider that if you depend on one company for your employment, your healthcare, and your stock portfolio, your entire financial well-being and future are tied to its failures or successes. You may feel an emotional attachment to the company, but you must be aware of the risk you carry by putting all of your financial eggs in one basket. If you intend to hang on to your ESPP shares long-term, consider that your investments should be providing reliable lifelong income as you near retirement.
Should You Sell Right Away?
To reduce risk, you can buy ESPP shares through payroll deductions and sell them as soon as possible. This method reduces your over-exposure to a single stock but does have tax implications. If both your current working income and a large portion of your wealth (through company stock ownership) are tied to your employer, then managing risk should trump any tax-saving strategies. In that situation, you should work toward aggressively reducing your investment risk by selling off some of the stock. If you own enough stock, you could also employ a covered call strategy that generates income on the stock while establishing pre-set price points at which you will sell it. However, you should fully understand this strategy and associated costs before implementing it. If you have substantial assets outside your company stock, then scheduling your stock sales in the most tax-efficient way may be more important.
Taxes on the Sale of ESPP Shares
When you purchase ESPP shares, you don’t owe any taxes. But when you sell the stock, the discount you received on the price is considered additional compensation, so the government will tax it. First, the difference between your offer price and fair market value is considered compensation income or earned income. This income is usually reported on your W-2. Next, the difference between what you paid for the stock and its value when you sell it—your gain or loss—is reported like any other capital gain or loss. Determining whether your profit is considered compensation income or capital gains—and in what proportion—depends on how long you’ve held it. If you held your ESPP shares for more than two years from the offering date and one year from your purchase date, it’s called a “qualifying position.” You can report more of your profit as capital gains rather than as earned income. You’ll benefit because the capital gains tax rate is lower than the tax rate for ordinary income. If you sell before those milestones, it is considered a “disqualifying position.” The discount you received is reported as income. Any additional profit is taxed as capital gains.
How Much Should You Sell?
Deciding how much company stock to hold, if any, depends on preference, risk tolerance, and investment goals. However, as a general rule, you shouldn’t hold more than 5% of your portfolio in a single stock. To find out whether you’re holding too much, add up the value of all your financial assets, such as savings, investments, and retirement accounts. Then divide the value of the stock you own into your total financial assets. If a single stock holding represents more than 5% of your financial assets, consider selling some. You can invest the proceeds in other assets that will increase the diversification and safety of your portfolio. Keep in mind the tax considerations outlined above. You can continue to purchase company stock through your ESPP program and sell your shares immediately to keep taking advantage of your discount; even though you’ll pay more income tax, you’ll reduce your risk of holding too much of a single stock. An accountant or financial planner can help you plan your strategy.
