When choosing a company to work for, people not only consider the salary, type of work, and culture, but also the benefits the company provides. Beyond salary and bonuses, another form of compensation an employer might provide is company equity in the form of stock plans.

While many may associate stock plans with high-profile tech companies from the news, stock plans are certainly not exclusive to that industry. They can be found in any industry and can be a significant factor in someone’s total compensation.

Along with restricted stock units and company stock options, another common stock plan is called an employee stock purchase plan (ESPP). In this plan, employees defer money from their paychecks to buy company stock shares, often at a discount. However, not all ESPPs are created equal, and tax considerations can be equally complex. If you have an ESPP, evaluating it is crucial in answering the question “Is an ESPP worth it?” This can help you decide whether you should participate or if it is more of a marketing tactic for the company.

In today’s post, we’ll review what an ESPP is, tax considerations, and some general best practices for evaluating and managing an ESPP. Then, we will put this together to answer the question “Should I participate in my ESPP?”

What Is an ESPP?

An ESPP is a stock plan provided by a company that allows employees to purchase stock of the company they work for over a period of time. Similar to contributing to a 401(k), money is withheld from each of your paychecks and set aside to buy the stock at a specified time. Like your 401(k), the exact details of each ESPP will vary. But each plan will generally consist of the following:

• ability to purchase company stock at a discount,
• a purchase period,
• and a holding period.

The discount offered within your ESPP determines what deal, if any, you get for participating in it. Typically, the higher the discount, the better deal your ESPP is. There is a 15% maximum discount on qualified ESPPs (more on qualified plans later), but an ESPP does not need to provide any discount at all. Nonqualified ESPP plans can have a discount percentage greater than 15, but a discount larger than that is rare.

Example: Mary participates in an ESPP that offers a 15% discount on her purchase price. On the purchase date, XYZ company is trading at $10 a share, and Mary had $850 taken out of her paycheck over the course of the purchase period. Since she gets a 15% discount, she can buy 100 shares at $8.50 a share.

The purchase period is the length of time that money is set aside to buy shares. Most plans have a purchase period of six months, but there can be other periods (e.g., 12 months or even 24 months). Money is set aside from each paycheck during that period and shares are bought at the end of it. Now, just because shares are bought eventually does not necessarily mean that the ending price is what the discount is based on. Some plans offer an incredible feature called a lookback period, which will take the lower price between the first and last days of the period to determine the price at which the stock is bought.

Example: Mike works for ABC company and is participating in its ESPP, which has a purchase period from January 1 to June 30. He contributes $900 and receives a 10% discount on the stock, with the added benefit of a lookback provision. On January 1, ABC stock is $10 per share; by June 30, it rises to $25. Because of the lookback, Mike gets the 10% discount off the lower January price, buying shares at $9 instead of $22.50. This allows him to purchase 100 shares, instead of just 40 without the lookback. Participating in an ESPP with a lookback provision lets him take advantage of price increases during the purchase period, turning his $900 contribution into $2,500 worth of stock immediately after purchase.

Another key consideration of an ESPP is whether it requires any holding period after you purchase the shares. Publicly traded companies report earnings and other important company details on a regular basis. Depending on the time of these reports and plan preference in general, there may be a holding or lockup period before you can sell your shares. This adds risk to the plan since, even if you receive a discount on the purchase, you have to hope the stock doesn’t drop in value between when you buy the shares and when you’re allowed to sell them.

Qualified and Nonqualified ESPPs

Taxes are a key factor in any financial decision. When it comes to ESPPs, not only can the discount be an attractive aspect, but if the plan is a qualified ESPP, there may be additional tax benefits as well.

A qualified ESPP is one that complies with Section 423 of the IRS code. A nonqualified plan is simply any other plan that does not meet the criteria of that code. Some key aspects of a qualified plan are:

• the discount portion of the plan cannot be more than 15%;
• a qualified plan can have a lookback feature, but the lookback cannot be longer than 27 months;
• plans without a lookback feature can have purchase periods extending all the way to five years if you are using the last day as the purchase price; and
• someone participating in a qualified ESPP cannot purchase more than $25,000 of stock through the plan during the calendar year, and the $25,000 value is based on the actual value of the stock, not the discounted purchase price.

There are, of course, other aspects that make up a qualified plan, but these are the major points. Your HR department should be able to tell you whether your ESPP is a qualified plan if you ask them.

In addition to the ESPP itself meeting specific criteria to be considered a qualified plan, you, as an employee who chooses to participate in an ESPP, must also meet holding requirements to receive favorable tax treatment. Specifically, you need to hold the stock for at least two years from the offering date and one year from the purchase date. If you sell the shares before meeting both of these time frames, the sale is considered a “disqualifying disposition” and won’t qualify for the more favorable tax treatment (more on that in a minute).

Example: Mary participates in a qualified ESPP, and her offering period starts on January 1, 2025, with stock being purchased on June 30, 2025. To receive favorable tax treatment, she must hold the stock until the later of:

• two years from the offering date (after January 1, 2027), and
• one year from the purchase date (after June 30, 2026).

If she sells the stock before meeting both of these requirements, the sale is considered a disqualifying disposition and does not qualify for the preferred tax treatment.

Tax Considerations of an ESPP

When you sell stock purchased at a discount through an ESPP, the profit is generally a mixture of ordinary income and capital gains or losses, depending on how long you’ve held the shares. The beauty with a qualified disposition is that more of the gain may be treated as long-term capital gains, which are usually taxed at lower rates than ordinary income.

Regardless of whether the sale is qualified or disqualified, the discount you received at purchase is always taxed as ordinary income. Where a qualifying disposition can shine and offer a real tax advantage is when your ESPP includes a lookback provision and the stock appreciates significantly. In a qualified sale, only the percentage discount (e.g., 15%) is taxed as ordinary income. The rest of the gain, including the growth from the lookback period, is taxed as long-term capital gains.

On the other hand, disqualified sales are much less favorable since both the discount and the entire gain from the lookback period are taxed as ordinary income. This can lead to a significantly higher tax bill.

Example: Mike starts this current round of ESPP on January 1, 2025, when his company, ABC, is valued at $10 a share. On June 30, 2025, the stock is valued at $25 a share, but his plan has a lookback period. Mike buys 100 shares at the January 1 price of $9 a share after the 10% discount ($900 of contributions).

Mike holds on to the shares until July 15, 2027, which is:

• more than two years since the beginning of the period, and
• more than one year since he bought the shares, making the sale a qualified disposition.

At the time of the sale, ABC company was trading at $50 a share. Mike has $100 of the transaction taxed as ordinary income from the original discount ($1 discount × 100 shares). The portion included as income is added to the basis of the sale. The remainder of the sale, $40 a share, is taxed as long-term capital gains ($50 – $10).

If the plan was not qualified, or if Mike did not meet the holding period requirements, then the lookback amount would also be considered income. In that case, $16 would be taxed as ordinary income ($25 – $9), with the remaining $25 per share taxed as long-term capital gains.

Of course, in the case of a disqualifying disposition, the appreciation is only taxed as long-term capital gains if you hold the stock for more than one year after the purchase. If you sell in less than a year, then any gain or loss is considered short term and typically subject to higher tax rates.

It’s also important to keep in mind that the discount is taxed as income and shows up on your W-2, regardless of the price at which the stock is sold. In an unfortunate situation, if the stock drops between when it was bought and sold, the discount amount is still taxed as income, even if the stock is now worth less than the discounted purchase price.

Should I Participate in My ESPP?

There is much to consider when deciding whether it’s worth participating in your company’s ESPP. The biggest factor is whether there is a discount and what the percentage is. If your plan does not offer any discount, you should almost certainly pass on participating. There is really no benefit in participating in the plan versus buying the stock yourself in the open market.

Plans that offer a generous discount and a lookback period should be strongly considered. The lookback option is what can make an ESPP incredibly valuable. An ESPP can provide significantly more monetary value if you get a discount and a more favorable price when you buy. A plan without a lookback provision should still be considered, but participating in a plan that includes both a discount and a lookback can provide immense value if the stock does well.

Lastly, even if the discount is generous and there is a lookback provision, you may still want to avoid participating in the plan if there are significant restrictions on when you can sell the stock. If your ESPP does not let you sell right away and may make you hold the stock for a few months, there is a risk that the stock may drop between when you buy and when you’re able to sell. This does not necessarily mean you shouldn’t participate, but you must be comfortable knowing that risk before making the decision to participate.

Making the Most of Your ESPP: How It Stacks Up Against Other Accounts

Of course, at the end of the day, whether it makes sense to contribute to an ESPP comes down to whether it helps you reach your financial goals. Depending on the plan, an ESPP can provide both financial and tax benefits. But if participating doesn’t move you closer to your goals, especially when compared to other available options, it may make sense to forgo contributing to an ESPP.

Participating in an ESPP competes with other savings alternatives. While it would be nice if everyone could max out their 401(k) and contribute to an ESPP, not everyone has the cash flow available to do this. Generally speaking, you should be contributing up to the employer match in a 401(k) before even considering setting aside additional money in an ESPP. The match is essentially free money provided by your employer. If it’s a dollar-for-dollar match, that’s a 100% return, which is significantly higher than a 15% max discount on a qualified ESPP.

While the tax benefits of a qualified ESPP can be great, an ESPP does come with risks. First, you need to hold the stock for at least a year after purchase to qualify for favorable tax treatment. Investing in an ESPP means concentrating money in a single company, your employer. That means your income, benefits, and investment performance are all tied to one entity. While no one wants to think their employer may have trouble, it does happen. Just ask the employees of Enron. That’s why it’s generally ill advised to have too much of your net worth tied up in your company’s stock. How long you plan to hold the shares and where you are in your overall savings journey are also key considerations.

You’ll also want to compare the tax benefits of an ESPP with other tax-advantaged options, like contributing to a traditional or Roth 401(k). If you’re already maxing out your 401(k), then participating in an ESPP could be a smart way to diversify your taxable investment accounts. But if not, you may be better off reducing your taxable income by contributing more to a traditional 401(k) or building tax-free savings in a Roth. At Milestone, we advocate for tax diversification, having a mix of tax-deferred, tax-free, and taxable accounts, but the right mix of these accounts depends heavily on your specific situation.

Lastly, depending on your personality, having money in an ESPP may not actually help you reach your savings goals. Once you have the stock and can sell it, the money is yours. If you view your ESPP as a savings vehicle but struggle to save the proceeds after selling the shares, using your ESPP may not be the best fit. Sometimes, putting money in a harder-to-reach place, like a 401(k), can be beneficial for people who lean more toward spending and have trouble saving. On the flip side, if you need quicker access to funds, an ESPP may offer more flexibility than a retirement account, helping you achieve shorter-term goals.

Clearly, there are many factors to consider when evaluating whether to contribute to an ESPP in terms of your personal tax situation, savings habits, time horizon, and overall goals.

ESPP Best Practices

We believe there are two main ways to manage ESPPs effectively, depending on your risk tolerance, personal situation, and goals.

1. The Conveyor Belt Method

The first approach is what we call the conveyor belt method. In this strategy, you’re participating in an ESPP strictly for its immediate financial benefits, namely the discount and any potential lookback provision, without aiming for a qualified disposition.

Think of a conveyor belt: You start contributing during the purchase period, building up funds through payroll deductions. At the end of the purchase period, the stock is bought, often at a discounted price, and, like a finished product coming off the belt, you sell the stock immediately. You lock in the profit from the discount (and the lookback, if applicable). The gain is taxed as ordinary income, but you avoid the risk of holding the stock after purchase.

Once the stock is sold, you start the process again with the next purchase period, just like resetting the belt.

The benefits of this method are clear: The risk is low and you’re typically locking in a profit, assuming the plan doesn’t require you to hold the stock for a set time before selling. This is generally our preferred approach for most people, because holding stock in the company you work for introduces additional risk. While a qualified disposition can offer favorable tax treatment, those benefits often don’t outweigh the risk of holding a concentrated stock position in your employer.

2. The Qualified Disposition Method

The second method is trying for a qualified disposition. You purchase the stock through the ESPP and hold it for at least one year from the purchase date and two years from the offering date to meet IRS holding requirements. This allows more of your profit to be taxed as long-term capital gains, which often results in a lower tax rate.

This method is best suited for those who are comfortable holding company stock and whose ESPP holdings represent only a small portion of their overall net worth. If you’re heavily concentrated in company stock or feel uneasy about the risk, it’s probably best to avoid this strategy.

That said, participating in an ESPP and holding for a qualified disposition can lead to meaningful tax savings, especially if your stock appreciates significantly. In addition, deferring the sale allows you to delay taxable income until a later year, which could help reduce your tax liability, particularly if you expect to be in a lower tax bracket down the road.

Wrap-Up

ESPPs can be a valuable benefit, but not all plans are created equal. Whether or not it makes sense to participate depends on several key factors, such as the size of the discount, whether a lookback provision is included, and whether there are restrictions on when you can sell the stock.

Beyond evaluating the plan’s features, it’s also important to think about the potential tax implications, especially when comparing your ESPP with other ways to save. Taking the time to understand how your ESPP fits into your overall financial plan will help you make a more confident, well-informed decision.

Stay informed of any changes that may affect your financial life by working with a financial advisor. There is a lot to consider when deciding on participating in an ESPP, and your circumstances are unique to you. If you need assistance with your financial planning or want a second opinion on your portfolio, please reach out to our team.