ESPP? In This Economy?

An ESPP allows employees to purchase shares at a discount with after-tax money. There is built-in profit when the shares are purchased.

Most people misunderstand Employee Stock Purchase Plans (ESPPs).

Even during the COVID stock market crash, I contributed the maximum to my employer’s ESPP.

As the stock price crashed, I still earned a 91.57% interest rate on my contributions.

A good ESPP generates hundreds or thousands of extra dollars with little risk. The strategy is simple:

1. Contribute the maximum feasible, respecting other short-term goals.
2. Receive shares at a 5–15% discount every purchase period (typically 3 or 6 months).
3. Sell the shares immediately and skim the profit as extra income.
4. Repeat every purchase period.

Selling immediately is crucial because holding the shares long-term is risky for most people.

The potential tax benefits of long-term ownership are not compelling when weighed against the volatility of a single stock. One bad news story could wipe out the entire profit or even cause a net loss.¹

Example

html `<figcaption>ESPP Interest Rate Calculator</figcaption>`;

viewof purchase_period_in_months = Inputs.select([3, 6, 12], {
  label: "Purchase Period",
  format: (m) => `${m} months`,
  value: 6,
});

viewof discount_percent = Inputs.number([0, Infinity], {
  label: "Discount (%)",
  step: 1,
  value: 15,
});

value_of_stock_per_dollar_contributed = (1.0 / (1.0 - (discount_percent / 100.0)));

html `<hr>`;

html `For every <strong>$1</strong> contributed, <strong>$${value_of_stock_per_dollar_contributed.toFixed(2)}</strong> worth of company stock is purchased`;

average_escrow_time_in_months = purchase_period_in_months / 2.0;
average_escrow_time_in_years = average_escrow_time_in_months / 12.0;
interest_rate = Math.pow(value_of_stock_per_dollar_contributed, 1.0 / average_escrow_time_in_years) - 1.0;

html `<hr>`;

html `On average, money is escrowed for <strong>${average_escrow_time_in_months} months</strong>`;

html `<hr>`;

html `Annualized interest rate: <strong class="fs-1">${(100.0 * interest_rate).toFixed(2)}%</strong>`;

Scenario: I contributed $850 over 6 months to an ESPP and receive $1,000 worth of stock (15% discount).

Question: What is the effective annualized interest rate if I sell immediately and receive $1,000 in cash (skimming $150 of profit)?

I think it is 91.57%. Can it really be true?

Consider that if I have $850 in some account and want my balance to be $1,000 in a year, I need a 17.65% interest rate:

\[ \begin{flalign} A &= P(1 + r) \\ 1000 &= 850(1 + r) \\ r &= \frac{1000}{850} - 1 \\ &= 0.1765 \\ &= 17.65\% \end{flalign} \]

It takes a full year at 17.65% interest to generate $150 from $850.

Intuitively the ESPP equivalent rate must be higher than an account paying 17.65% interest.

With ESPP, I contributed $71 twice per month for 6 months (totaling approximately $850).

The first $71 was escrowed for about 6 months, the next $71 for 5.5 months, etc. until the final contribution for only a few days or weeks. On average, one of my dollars was tied up for approximately 3 months (half of the purchase period).

So yes, $850 that turns into $1,000 in 3 months works out to an exceptionally high 91.57% annualized rate:

\[ \begin{flalign} r &= \biggl(\frac{A}{P}\biggl)^t - 1 \\ &= \biggl(\frac{1}{1 - discount}\biggl)^t - 1 \\ &= \biggl(\frac{1}{0.85}\biggl)^4 - 1\\ &= 0.9157 \\ &= 91.57\% \end{flalign} \]

\(t=4\) because there are 4 3-month quarters in a year.

To calculate ESPP profit for your own plan, try the tool on the right.

In summary, the ESPP “sticker” discount rate of 5–15% is not the full story!

Lookback

html `<figcaption>ESPP Interest Rate Calculator (with lookback)</figcaption>`;

viewof lookback_purchase_period_in_months = Inputs.select([3, 6, 12], {
  label: "Purchase Period",
  format: (m) => `${m} months`,
  value: 6,
});

viewof lookback_discount_percent = Inputs.number([0, Infinity], {
  label: "Discount (%)",
  step: 1,
  value: 15,
});

viewof lookback_price_at_start = Inputs.number({
  label: "Stock Price (start)",
  type: "number",
  step: 0.5,
  value: 100,
});

viewof lookback_price_at_purchase = Inputs.number([0, Infinity], {
  label: "Stock Price (purchase date)",
  type: "number",
  step: 0.5,
  value: 105,
});


html `<hr>`;

{
  if (lookback_price_at_start < lookback_price_at_purchase) {
    return html `The stock <strong>rose</strong> in value.<hr>The ${lookback_discount_percent}% discount is applied to the <strong>Stock Price (start)</strong> price.`;
  } else {
    return html `The stock <strong>fell</strong> in value.<hr>The ${lookback_discount_percent}% discount is applied to the <strong>Stock Price (purchase date)</strong> price.`;
  }
}

lookback_purchase_price_with_discount = (1.0 - (lookback_discount_percent / 100.0)) * Math.min(lookback_price_at_start, lookback_price_at_purchase);
html `<hr>`;

html `Each share is purchased for <strong>$${lookback_purchase_price_with_discount.toFixed(2)}</strong> and is immediately worth <strong>$${lookback_price_at_purchase.toFixed(2)}</strong>`;

lookback_average_escrow_time_in_months = lookback_purchase_period_in_months / 2.0;
lookback_average_escrow_time_in_years = lookback_average_escrow_time_in_months / 12.0;
lookback_interest_rate = Math.pow(lookback_price_at_purchase / lookback_purchase_price_with_discount, 1.0 / lookback_average_escrow_time_in_years) - 1.0;

html `<hr>`;

html `Annualized interest rate: <strong class="fs-1">${(100.0 * lookback_interest_rate).toFixed(2)}%</strong>`;

The best ESPPs offer a lookback feature.

With a lookback, the discount is applied to the price at the start of an offering period or the price on the purchase date, whichever is lower.

“Whichever is lower” makes it difficult to lose.

When the stock rises in value, shares are purchased at a discount from the earlier price, leading to even higher built-in profit.

When the stock falls in value, shares are purchased at a discount from the current market price on the purchase date.

There is profit in either scenario as long as the shares are sold immediately to lock in the gain.

To calculate ESPP profit for your own plan that has a lookback feature, try the tool on the right.

Try different scenarios, including ones where the stock loses value over the purchase period. It is still pretty good, right?

A lookback feature, if it exists, will be described in the plan documents.

Caveats

ESPP administration and tax law have caveats that change the math in some scenarios. However, I have never seen these issues alone make a plan undesirable.

For instance, volatility in the stock price between the purchase date and when the stock can later be sold means the profit will inevitably be a little higher or lower than the calculators show. I limit the impact of this volatility by having a recurring reminder to sell as quickly as possible.

Commissions and fees reduce the effective interest rate slightly.

Some plans allow purchasing partial shares. Others may only allow whole shares; in that case, the “change” will be refunded on a future paycheck.

Qualified (tax efficient) plans under §423 are limited to $25,000 of stock per year². With a 15% discount, the maximum contribution works out to be $21,250.

Plans with a lookback feature calculate the maximum number of shares per purchase period from the price at the start of the offering period. If the stock falls in value during this offering period, the maximum number of shares may be worth less than the maximum dollar contribution in later purchase periods. Money that cannot be used to purchase shares will be refunded, but it will also lower the effective interest rate.

Most plans allow employees to withdraw during a purchase period and have the accrued money refunded on a future paycheck. There may be significant delay between withdrawing from the plan and receiving the money.

Some people consider strategically withdrawing based on movement in the stock price. I have yet to see a case where the return on hassle is compelling. ESPP is best left as a mechanical process to generate extra income every purchase period.

If an employee is terminated (voluntarily or involuntarily), money contributed during a purchase period will be refunded on their final paycheck or shortly after.

Do you need help?

How does an ESPP fit into a tax-efficient financial plan? It will always come down to an individual’s specific goals and circumstances.

But good plans have such a high effective interest rate that anyone who can afford to defer income for a few months may want to consider them.

I offer consulting about ESPP and many other tax topics. Reach out if I can help.

Footnotes

1. Some ESPPs restrict employees from selling their purchased shares immediately. That makes participating in the ESPP more risky, and it may be too risky for some people in these cases.

2. $25,000 was written into law in 1964 and has not changed since. The BLS CPI calculator estimates this amount as $258,737 in today’s dollars as of March 2025.