Whether you're already using your ESPP plan with Cisco or have no clue what an ESPP is, please take a minute to read this. My hope is that it will
Give you a better understanding of your Cisco ESPP.
Help you maximize the investment value of your ESPP.
Understand and/or reduce the tax implications of the ESPP investment.
ESPP plans are an employee incentive program that allows participants to purchase company stock at a discounted price relative to the current stock market price.
These types of plans can be extremely lucrative and are intended to promote employee performance and retention with the company.
Let's take a look at how they work, some examples, tax involved, and some strategies for maximizing this benefit.
Structure of your Cisco ESPP.
When participating in your ESPP, you're given he opportunity to purchase shares of Cisco stock at a discounted price-- something that cannot be done outside of the plan.
You are generally able to participate in the Cisco ESPP if you are an active employee with the company as of the "offering date" (discussed below) and scheduled to regularly work 20 hours per week for at least 5 months out of each calendar year.
Cisco structures their ESPP around consecutive and overlapping 24-month offering periods. Each offering period has a total of four purchase periods and corresponding purchase dates, each purchase period lasting 6 months. Here is a visual of the structure.
To participate in an ESPP offering period you must enroll by the deadline which is established by the plan administrator. Typically paperwork and notification procedures should be closely followed to make sure you have everything turned in accurately and on time.
Upon enrollment, you're able to choose how much money you'd like to invest in your ESPP plan. You can elect to participate in increments of 1% of your Eligible Earnings, with a maximum contribution limited to 10% of your Eligible Earnings. Investments into the ESPP come directly out of your paycheck, after tax.
How the investment works.
After enrolling in the ESPP offering period and choosing your check deferral amount, your contributions will be drafted from your check over the duration of the purchase period.
At the beginning of the offering period, the stock price of CSCO will be established and recorded. For example, if the offering period started on January 4th, 2021 the price of Cisco Systems Inc. stock (CSCO) would have been recorded as $43.65.
After everything is started and established, check deferrals into the plan will continue through purchase period #1. Your contributions will sit around as cash in a general account managed by the ESPP plan administrator until purchase date #1 which marks the end of the first purchase period.
This is when it starts to get fun.
The money you've added to your ESPP throughout the purchase period will now be used to buy CSCO stock at a 15% discount from the stocks closing price on the purchase day.
Example: Cisco stock closes at $50 on June 30th (purchase date). Your ESPP contributions will be used to purchase the stock at $42.50... 15% lower than the current share price.
After you purchase the stock at its discounted price, you have 2 options.
Sell the shares immediately and lock in your 15% gain.
Hold the shares and sell later.
Another wrinkle: the Cisco stock purchase plan has a special look back provision...
Remember that recorded stock price of $43.65 at the beginning of the purchase period? If that recorded stock price is less than the stock price at the end of the purchase period, you'll purchase the stock at a 15% discount from the lower price recorded at the beginning of the period. So in this example, you would acquire CSCO at $37.10 which is more than a 25% discount from its current market share price of $50!
Maximize your Cisco ESPP.
If you haven't figured this out yet, you have an easy path to growth your money at a rate 15%. Here's how that would work:
Your eligible income at Cisco Systems, Inc. is $200,000 so you fund the ESPP with $20,000 (10% maximum).
The stock price on the purchase date is higher than at the start of the offering period so you acquire the stock at a price 15% lower than its current market value. Then, you immediately sell the stock at fair market price and realize a gain of 15% on your $20,000 investment.
In 6 months, you turned your $20,000 investment into $23,000... essentially guaranteed if you immediately sell your shares. This is equivalent to a before tax investment return rate of 30%!
Speaking of taxes, you'll need to pay taxes on your investment gains, which I'll discuss later.
If there was a bank in town that was paying 15% on deposits (which is also taxable), people would be lined up for miles to open accounts and deposit their savings.
This is why it's generally a good idea you to maximize your contributions to your ESPP plan at Cisco, if you can.
Strategic planning ideas for your ESPP.
1. The first and most obvious way to milk everything out of your Cisco ESPP is to put as much money as you possibly can into it. Again, you can contribute up to 10% of your eligible income up to an annual IRS maximum of $25,000. This rule especially applies to people who have more than enough cash sitting in back accounts... earning less than 1%.
2. Decide your overall tolerance for investment risk, how you think CSCO will perform over the coming year(s), and make an appropriate decision to either sell or hold your CSCO stock after the purchase dates.
You have two options after you acquire the stock: sell the stock or hold the stock. Selling the stock would lock in your "15% discount gain". If you held the stock, however, your investment would fluctuate as CSCO performs in the stock market. Therefore, if the stock goes up you may have the chance to realize a gain that is greater than 15%, but if the stock declines, your investment return will start to dwindle.
This is why its important to have an opinion as to the outlook of the company and its future stock performance. It's nearly impossible to predict the performance of a stock but if you like the company and are okay with holding the stock for many years it could make sense to hold the stock for several years. Holding the stock for more than a year also has tax advantages which I'll mention here in a bit.
3. Withdraw from an offering period that has an initial stock price on record that is significantly higher than the current market price.
I didn't mention this earlier but another feature of your ESPP at Cisco is the ability to opt out of an offering period, and re-enroll in the next offering period when the time comes. For example: you enroll in the January 2021 ESPP offering period but decide to withdraw before the 2 year offering period expires, and you instead re-enroll in the very next offering period starting January 2022.
When you withdraw from an offering period, your can elect to either finish out the current purchase period or get your accumulated contributions back in cash.
The reason behind this strategy is pretty simple. If the current market price of CSCO is significantly lower than the initial price on the offering period start date, you'll always be purchasing the CSCO stock at a 15% discount from its current price (purchasing at a 15% discount from the higher initial stock price doesn't make sense...).
If however you withdraw from the offering period while the stock is declining, your initial stock price marking the beginning of the next offering period will be lower -- increasing the odds that you'll use the larger look back discount on future purchase dates.
4. Strategizing tax implications on your ESPP....
Is your Cisco ESPP taxed?
Yes.
You will owe tax on your ESPP investment while you participate. The amount of tax you pay will be determined by several factors including your household income, the "holding period" of your investment (compared to the purchase date and offering date), the market price of the stock on purchase date and sell date, and your discounted purchase price.
Generally, when you investment money you'll be taxed at either short or long term capital gains rates. It's preferred to be taxed at long term capital gains rates because they are lower than short term rates (short term capital gains rates = ordinary income rates).
When you hold an investment for more than 1 year you are taxed at favorable long term rates. If you hold an investment for less than 1 year, you are taxed at short term rates.
There are 2 holding periods that are important for Cisco ESPP plan participants:
The 1 year holding period starting on the purchase date(s).
The 2 year holding period starting on the offering date.
If satisfy the first holding period (hold the shares 1 year after the purchase date) you will pay long term capital gains tax on any growth over your purchase price of the stock on the offering date and the stock price on the day you sell.
If you satisfy the second holding period (hold the shares past 2 years from the beginning sate of the offering period) you will only pay ordinary income tax on the difference between the stock price on the offering date and your discounted purchase price.
The above scenario is know as a "Qualified Disposition". Here is an example with some numbers.
Example #1: Tom invests $12,500 into his ESPP during purchase period 3. The initial offering price in January 2021 was $40 and the price of the stock on the purchase date is $50. Tom's purchase price is $34 which represents a 15% discount from the lookback price of $40.
His $12,500 investment allows him to purchase about 367 shares. He decided to hold the shares until August 1, 2024 which is both 1 year past the purchase date (6/1/2022) and 2 years past the offering date (1/1/2021). Let's take a look at Tom's investment gain and resulting tax bill.
Investment Gain: Sale price $22,020 - $12,500 investment = $9,520 gain.
Ordinary Income: $40 - $34 = $6 per share. $6 x 367 = $2,202 will be taxed at ordinary income rates.
Long Term Capital Gains: $60 - $40 = $20 per share. $20 x 367 = $7,340 will be taxed at long term capital gains rates.
If you fail to meet both holding periods by either selling shares before the 1 year holding period after purchase or before the end of the offering date, the taxes work differently.
If you sell the shares within a year of the purchase date(s), you'll pay short term capital gains (remember, this is the same as ordinary income) on the difference between the share price on the purchase date and your sale date.
If you sell your shares before the end of the 2 year period after the offering date, you'll owe ordinary income on the difference between your discounted purchase price and the price of the stock on the purchase day. This scenario is known as a "Disqualified Disposition" and here is an example.
Tom's brother Fred also works at Cisco and contributes the same amount of money into the Cisco ESPP. He decided to sell his shares on August 1, 2022 which meets neither of the holding period requirements. Here is how his investment gain and tax liability would look.
Investment Gain: Same gain as Tom $9,520
Ordinary Income: $50 - $34 = $16 per share. $16 x 367 = $5,872 will be taxed at ordinary income.
Short Term Capital Gain: $60 - $50 = $10 per share. $10 x 367 = $3,670 will be taxed at short term capital gains rates.
Remember that short term capital gains are taxed as ordinary income. So all of Fred's $9,520 gain will be taxed in his ordinary income bracket.
The last wrinkle to this whole thing is that the actual tax bill that is owed to the IRS will depend on Tom and Fred's household income tax bracket, which determines their capital gains brackets. This is why tax planning is essential to fully maximizing your ESPP plan at Cisco.
Analyzing your tax situation throughout the year and deploying the appropriate ESPP buy/sell/hold strategy is how you really maximize this investment.
I know this might be a lot to digest and it may take rereading a few times to really lock it in.
Here is how I would summarize everything for now.
Selling your shares quickly after the purchase date will result in less favorable tax treatment of your investment.
Since we've discussed quickly selling shares after the purchase date to lock in your 15% "discount gain", there is a clear trade off between potentially larger investment returns coinciding with a larger tax liability.
In essence, this is another reason why it's important to have a long term outlook and some type of strategy while participating in the Cisco Employee Stock Option Plan.
If you don't feel like you can handle everything on your own (admittedly this is a lot), consider working with a qualified financial professional to get some guidance.