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A:   An Employee Stock Purchase Plan (ESPP) is a company-sponsored employee benefit which allows participants to purchase company stock through payroll deferral.  Most ESPPs allow participants to buy shares at a discount from the market price.  The discount is generally applied to the lower of the beginning price or ending price during a designated offering period (a time-frame usually ranging from three to six months, depending on the plan).  This means at the time of purchase, ESPP shares’ built-in profit may be even greater than the stated discount, as participants benefit if the stock price appreciates during the offering period. 

The discount varies from plan to plan, but can be as much as 15%.  Opportunities to earn an immediate return on investment don’t come along very often.  Consequently, we generally recommend anyone who is eligible to participate should consider doing so.

Here are some details to consider: 

Tax Considerations

Although contributions to an ESPP are made through payroll deferral, they are not tax-advantaged like 401(k) plan deferrals.  There is no tax-deduction for contributions to an ESPP.  Furthermore, the discount on stock purchases is considered compensation for tax purposes.  Taxable income is not recognized, however, until the shares are disposed of through a sale or gift to another party.  When shares are sold, this “disposition” of shares is characterized as either “qualified” or “disqualified” depending on how long the shares were held.  Whether a disposition is qualified or disqualified dictates how much of the sale proceeds are considered ordinary income versus capital gain/loss.

Qualified Dispositions

The sale or gift of ESPP shares is considered “qualifying,” if both of the following criteria are met: 

1. The shares must be held for at least twelve months from the date of purchase.
2. The shares must also be held for at least twenty-four months from the grant date (generally defined as the first day of the offering period).

If the disposition is deemed “qualifying,” compensation income is the lesser of two numbers:

1. The difference between the market price and the discount price calculated on the grant date (not necessarily the actual purchase price).
2. The difference between the sales price (or market price when gifted) and the purchase price.

Disqualifying Dispositions

The sale or gift of ESPP shares is considered “disqualifying,” if both the criteria above are not met.  If the disposition is deemed “disqualifying,” compensation income is the difference between the market price on the date of purchase and the actual purchase price.

Capital Gain or Loss

In both qualifying and disqualifying dispositions of ESPP stock, cost basis is calculated by adding the compensation income to the actual purchase.  The difference between the sales price and the cost basis is either a gain or loss.  The gain or loss is considered short-term if the shares were held less than twelve months from the time of purchase and long-term if held longer than twelve months. 

Quirky Transactions

A disqualifying disposition of ESPP shares that have declined sharply since purchase can result in paying taxes on “phantom income.”  Remember, the compensation income in a disqualifying disposition is the difference between what was paid and how much the shares were worth at the time of purchase.  That is true even when a subsequent decline erases that initial profit.  Under this scenario, with only up to $3,000 of capital loss allowed to offset income—an ESPP participant might end up paying taxes on income that no longer exists.  A qualifying disposition in this same scenario results in no compensation income. 

Finally, in an instance in which the share price declines during the offering period, but then appreciates prior to when the ESPP shares are finally sold, a disqualifying disposition can actually result in less tax than a qualifying one. 

Obviously, it pays to be aware of the implications of ESPP dispositions across different holding period and stock price scenarios.

Index funds, by contrast, are more tax friendly by nature.   As there is no manager darting in and out of stocks based on market forecasts, trading activity is reduced.  Fewer trades help keep a lid on transaction costs, and also minimize realized capital gains.  By simply tracking the market, index funds ensure the lion’s share of return lands in investors’ pockets. 

Consider Vanguard’s Total U.S. Stock Market Fund (symbol VTI).  The fund, which invests in all publicly-traded U.S. stocks, returned 1% in 2011.  Taxes on dividends reduced that by 0.3%, resulting in an after-tax return of 0.7%.  That may not seem like much.  But in 2011, it was nearly 5% more than what the average fund investor took home.

Longer term, the story is much the same.  From 2001 through 2010, Vanguard’s Total U.S. Stock Market Fund earned 3.75%.  With a tax burden of just 0.31% per year, 3.44% made its way to investors’ bottom lines.  Actively-managed large cap stock funds earned 3.22%, on average, before tax.  Taxes ate 0.73%, leaving only 2.49% for investors.

How much do taxes matter?  For every $1,000,000 invested, the difference between 3.44% and 2.49%, compounded annually over ten years, is $123,600.

Beyond making the tax-savvy decision to favor index funds, a few additional strategies Vista employs help ensure taxes don’t take too big a bite out of our clients’ returns:

• Asset Location—Place highly-taxed assets (e.g. bonds and REITs) in tax-deferred accounts and favor more lightly-taxed stocks in taxable accounts.
• Tax Loss Harvesting—Trim positions trading at a loss, immediately replace them with a similar investment, and use the realized (“harvested”) losses to wipe out future gains.
• Municipal Bonds—Favoring tax-free over taxable bonds often has appeal for clients in higher tax brackets.  A muni bond yielding 3% delivers the same income as a 4.5% taxable bond.

We recognize how boring these strategies may appear relative to the dizzying complexity peddled by Wall Street.  And therein lies their appeal:  simple, sensible and quietly effective.  It sure beats salt in the wounds.

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This new fund invests in top-rated, non-U.S. government bonds.  These bonds complement our existing holdings in high-quality U.S. Treasury Bonds, Treasury Inflation Protected Securities (TIPS), and tax-free municipal bonds.  When investing in bonds, our primary objective is safety and capital preservation during periods of stock market distress.  High-quality international government bonds help fulfill this objective.^[1]

¹ International Bonds are represented here as the weighted average of the following countries’ 1-5 Yr hedged government bonds: Japan—20%; France—15%; UK—15%; Germany—14%; and 4% each of Austria, Canada, Denmark, Finland, Netherlands, New Zealand, Norway and Sweden. U.S. Bonds: Barclays Capital Treasury Bond Index 1-5 Years. U.S. Stocks: S&P 500 Index. Average Return is 1995-2011. Great Recession is 11/2007-02/2009. Tech Bubble Burst is 04/2000-03/2003. All returns annualized.

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