Last month I discussed how valuable Health Savings Accounts are, how they can significantly increase your wealth over time, and why I generally prefer them over 401k accounts. But how do HSAs fare when compared to Employee Stock Purchase Plans (ESPPs)? If you only have enough money to contribute to one, which one should it be?
ESPPs are essentially an opportunity for employees to buy company stock. I recognize that not everyone has this opportunity, but if you do, then the ESPP is something you likely should be considering.
The Value of ESPPs
Each employer will have it’s own set of rules regarding how ESPPs work; however, I’ve usually seen them work in the following manner. Usually an employee can purchase employer stock at a 15% discount. This alone is a huge benefit as this equates to a 15% return. Further, some employers will offer a look-back period and let you apply the discount to the lower of the offering price or purchase price over a set time frame, which could magnify your returns.
It’s important to know that the IRS caps yearly contributions at $25k and the discount at 15%.
Should You Contribute to an ESPP?
We generally recommend that everyone maximize contributions to their ESPP if there is a discount and if the shares can be sold immediately after purchase. Some employers impose a vesting period which requires you to wait before you sell the stock. This creates a lot of risk since you are invested in one company and your profit could be wiped out entirely. In these circumstances, participating in an ESPP is not as attractive.
But, if you can sell your stock immediately after you purchase it, then you can lock in your profit and use the proceeds to reinvest in more diversified and less risky manner. You will owe ordinary income taxes on the entire amount of the gain if you sell your shares immediately, buy in my opinion, this is worth it considering that you have a sizable built in profit.
As an example, if you can purchase shares at a 15% discount, this equates to a pre-tax return of 17.65% (i.e. a $10 stock purchased for $8.50 provides a 17.65% return). If we factor in a tax bracket of 22%, then your after-tax return is still very attractive at 13.77%. Not bad for free money!!! So long as you can sell your shares immediately after purchase, you are guaranteed at least a 17.65% pre-tax return if the discount is 15%. The guaranteed return is lower if the discount is smaller.
The return could be significantly higher if you get the benefit of a lower purchase price, thanks to the look back period, and if the price of the stock goes up. For example, if the original price of the stock at the offering period is $10 and it rises to $20 at time of purchase, then the look back period will let you buy the stock at $8.50 ($10 minus the 15% discount). You now would own stock valued at $20, yet you only paid $8.50. This is a return of 135%!
ESPP vs. HSA, Which One Wins?
I don’t think there is a cookie-cutter answer to where one is always better than the other.
As your tax bracket increases, HSAs become more valuable since your tax bracket is essentially your guaranteed return. If you are in the top 37% tax bracket, then you are guaranteeing yourself a 37% return. However, your HSA would face income taxes (and possibly penalty taxes) if the funds are used for non-medical reasons.
ESPPs, on the other hand, are more valuable if there is a 15% discount, a look back provision, and an ability to immediately sell the stock after purchase. If these provisions exist and the stock price increases substantially, you could walk away with a very sizable, immediate profit; potentially much more than the HSA. Even if the stock doesn’t rise substantially, you are still guaranteed the 17.65% return. Further ESPP funds can be used for whatever you want; you are not limited to medical costs like you are with the HSA.
If you only had enough money to contribute to one, then I would lean toward the ESPP, so long as it at includes the provisions listed above. If the discount is less or if there is not a look back provision, then the ESPP becomes less valuable. My co-worker, Daniel Berg, came up with a great solution here. He suggested that if you only had $8,300 / yr to invest (which is the HSA max contribution for a family), then contribute this amount to the ESPP in year one. Then in year two contribute another $8,300 plus the contributions and earnings from year one. Keep doing this for three years. At the end of year three, you should have enough money accumulated from the sale of all the ESPP stock to keep funding the ESPP each year ($25,000) plus maximize contributions to the HSA ($8,300).
If you can afford to maximize contributions to both the ESPP and HSA, then sign up right away, even if it means forgoing contributions to your 401k (note, please at least contribute enough to the 401k to get the free company match).
Please comment below and let me know your thoughts on this subject.
Brad Tinnon
CERTIFIED FINANCIAL PLANNER™