When to Sell ESPP Shares
Selling Right Away Can Affect Your Taxes but Reduce Your Risk
An employee stock purchase plan (ESPP) allows you to buy shares of company stock at a price below market value. The terms of each plan differ, but generally, you'll see a discount of about 10%–15%. You agree to payroll deductions to fund the purchase, and at certain points in the year, your company purchases the stock for you. This discounted price is also called the offer, or grant, price.
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 being riskiest, owning a single stock is a level 5. By holding a single stock, you're subject to industry risk, management risk, and event risk. Even large, seemingly stable companies aren't immune; for example, Enron employees whose retirement funds were mostly composed of company stock saw declines of 90% in just one year, before the company's bankruptcy.
Consider also that if you depend on one company for your employment, your health care, and your stock portfolio, your financial well-being is completely tied to its failures or successes. You may feel an emotional attachment to the company, which is common, but you must be aware of the risk you carry by putting all your financial eggs in one basket.
If you intend to hang on to your ESPP shares long-term, also consider that as you near retirement, your investments should be providing reliable lifelong income. The volatility of the stock market makes this difficult if your wealth is concentrated in a single stock.
Should You Sell Right Away?
To reduce risk, you can buy ESPP shares through payroll deductions and sell them as soon as possible. This reduces your overexposure to a single stock but does have tax implications.
If you find a great deal of your financial security is tied to your employer, meaning both your current income while working and a large portion of your wealth through the ownership of company stock, then managing risk should trump any tax-saving strategies. In this situation, 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, although you should fully understand this strategy and associated costs before implementing it.
If you have substantial assets outside of 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.
There are several factors to consider when it comes to the taxes you'll pay on ESPP stock.
First, the difference between your offer price and fair market value is considered compensation income or earned income. This 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 just 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 the stock. 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, and you are able to 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, and 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. Now 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.
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.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.