Are ESPP Contributions Before or After Tax?

An Employee Stock Purchase Plan (ESPP) is a company-run program that allows you to purchase company stock, often at a discount. These plans enable you to set aside money from your paycheck over a period of time, known as an offering period. At the end of this period, the accumulated funds are used to buy shares on your behalf. Many plans offer a discount of up to 15% on the stock’s market price, and some include a “lookback” feature that applies this discount to the lower of the stock price at the beginning or end of the offering period.

ESPP Contributions from Your Paycheck

When you participate in an ESPP, the contributions are deducted directly from your paycheck using after-tax dollars. This means your employer calculates and withholds income taxes based on your gross pay, and only then is your designated ESPP contribution taken out. The funds are then held by the company until the predetermined purchase date.

This after-tax treatment is different from contributions to a traditional 401(k) plan, where you contribute pre-tax dollars to lower your taxable income. ESPP contributions do not provide this immediate tax reduction; the tax implications arise when you sell the purchased shares.

Tax Implications When You Purchase Stock

For most ESPPs that are “qualified” under Internal Revenue Code Section 423, the moment you purchase the stock is not a taxable event. You do not owe any tax on the discount you receive at the time of purchase, even if the plan allows you to buy shares at a 15% discount.

Following the purchase, your employer will provide you with Form 3922, Transfer of Stock Acquired Through an Employee Stock Purchase Plan. This is an informational document containing details you will need later, such as the stock’s fair market value, the purchase price, and the number of shares acquired. You must keep this form for calculating your taxes when you eventually sell the stock.

Taxation When You Sell Your ESPP Shares

The tax consequences of selling your ESPP shares depend on how long you hold them. The holding period determines whether the sale is a “qualifying disposition” or a “disqualifying disposition,” each with different tax treatments.

A qualifying disposition offers more favorable tax treatment and requires meeting two holding period rules. First, the sale must occur more than two years after the offering date (the grant date). Second, the sale must also be more than one year after the purchase date.

In a qualifying disposition, a portion of your profit is taxed as ordinary income, and the rest is treated as a long-term capital gain. The amount reported as ordinary income is the lesser of two calculations: the discount offered by the plan based on the offering date price, or the actual gain on the sale. Any remaining profit is taxed at long-term capital gains rates.

A disqualifying disposition occurs if you fail to meet both holding periods. For example, selling shares within a year of the purchase date is a disqualifying disposition. In this scenario, the “bargain element”—the difference between the fair market value of the stock on the purchase date and the discounted price you paid—is taxed as ordinary income. Any additional profit is taxed as a capital gain, which could be short-term or long-term depending on whether you held the shares for more than one year.

Reporting the Sale on Your Tax Return

When you sell your ESPP shares, you must report the transaction to the IRS. You will receive Form 1099-B from your brokerage and will need the Form 3922 from your employer to complete Form 8949, Sales and Other Dispositions of Capital Assets. This information is then used for Schedule D (Capital Gains and Losses).

An important part of this process is adjusting the cost basis reported on Form 1099-B. Brokers often report the unadjusted cost basis, which is what you paid for the shares. You must increase this basis by the amount of compensation income that was reported on your W-2 (for a disqualifying disposition) or that you must report as ordinary income (for a qualifying disposition).

This adjustment is made on Form 8949 and is necessary to prevent being taxed twice on the same income. Using Form 8949, you will report the sale, make the cost basis adjustment, and calculate the final capital gain or loss for Schedule D.