How to Take Advantage of Employee Stock Purchase Plans

Dear Dr. Don,

My husband and I are in our early 40s with three children -- the oldest is seven, the youngest just four months. Our combined gross income is $111,000. We own a home worth about $600,000 with a hefty mortgage balance of $400,000. We are primarily concerned with funding our retirement at 65. Grandma is funding a Section 529 College Savings Plan for the kids. We figure that we might take out a home equity loan if we need the money for college.

My husband's company offers a stock purchase plan every two years. The plan offers a minimum discount of 15% off the market price of the stock. Should we invest in this? I am concerned that we will be too heavily weighted in his company stock, but my husband thinks the 15% discount is too good to pass up.

We have no taxable investments, and cash flow is a big concern right now with that mortgage. We are pretty aggressive, but looking at this list, maybe we are too comfortable with the S&P 500 index fund!!

Any suggestions?

AM

AM's IRA Account
Name	Shares	Market Price	Market Value	% Total Value	YTD Return	Morningstar's Stock Industry or Fund Category
(VFINX)Vanguard 500 Index	135	110.02	14,853	8.6%	-9.3%	Large Blend
(VIGRX)Vanguard Growth Index	495	26.53	13,132	7.6	-13.0	Large Growth
Account total:			27,985	16.2%
AM's 401(k) Account
(MCSAX)MainStay Capital Appreciation A	330	33.97	11,210	6.5%	-21.8%	Large Growth
Account total:			11,210	6.5%
AM's Spouse's 401(k) Account
(PEOPX)Dreyfus S&P 500 Index	2,750	34.85	95,838	55.6%	-9.5%	Large Blend
Cooper Industries(CBE)	645	57.78	37,268	21.6	27.9	Electric Equipment
Account total:			133,106	77.3%
Portfolio total:			172,301	100.0%

Dear AM,

With Cooper Industries(CBE) in the news, you've seen the stock reach a three-year high. While that's helped your portfolio's overall return, the possibility of a merger also illustrates the problem with being invested too heavily in your company's stock. Putting your human and financial capital to work at the same firm subjects you to additional risk.

Employee Stock Purchase Plans, or ESPPs, typically allow workers to set aside up to a maximum of 10% of their gross pay to buy company stock for a discount of up to 15% through payroll deductions. Where this gets interesting is that the 15% discount is calculated based on the market price of the stock at the beginning or end of the purchase period, whichever is lower. The look-back period usually runs six months but can be as long as 27 months. That means the stock can have a much larger gain than the 15% discount.

To qualify as a capital gain, the shares have to be held by the employee for at least one year after he or she exercises the right to buy the shares, and two years after the right was granted. If he or she doesn't hold the stock long enough to meet the holding-period requirements, some of the gain on the sale of the stock will have to be reported as compensation income (i.e., wages) instead of capital gains. This IRS Web page provides additional information.

There's really no substitute in this area for professional tax advice that allows you to take advantage of the ESPP while managing the percentage of your wealth that is invested in the company's stock.

Your emphasis on investing in S&P 500 stocks may be greater than you realize. The (VIGRX)Vanguard Growth Index tracks the S&P 500/Barra Growth Index, which is a capitalization-weighted index of the growth stocks in the S&P 500. The index tracks the half of the S&P 500 stocks with the highest ratio between book value and stock price, or book-to-price ratio. So your Vanguard Growth Index investment is also invested entirely in S&P 500 stocks. Add to that your investment in (MCSAX)MainStay Capital Appreciation, another mutual fund specializing in large-capitalization growth stocks, and you're right to be concerned about the portfolio's emphasis on large-cap growth stocks.

Adding a foreign stock fund and a mid-cap stock fund to the portfolio while reducing the emphasis on large-cap growth stocks will improve the portfolio's diversification. Start your shopping by looking at the (TBGVX)Tweedy Browne Global Value Fund, (BUFSX)Buffalo Small Cap and (VIMSX)Vanguard Mid-Capitalization Index. Use your IRA account for the specialty funds while using the 401(k) accounts for the index funds.

Don't forget to keep an eye on your annual expenses and sales loads. You're paying a front-end sales load of 5.50% on the MainStay Capital Appreciation Fund, along with annual expenses of almost 1%. It's not unusual for a 401(k) plan to have limited choices, but the idea behind paying a sales load is to compensate a financial adviser for his time in helping you decide on an appropriate investment. Getting his firm selected as a plan provider doesn't count as time spent on your account. If you're not getting any advice for that commission, you should lobby your employer for some no-load fund options. According to Morningstar, this fund's annual expense ratio is less than the average for this type of account, but you're still paying a lot for a fund that isn't beating either the S&P 500 or the S&P 500/Barra Growth Index.

Paying 0.50% in annual expenses for the (PEOPX)Dreyfus S&P 500 Index in your spouse's 401(k) account is expensive when compared with the (VFINX)Vanguard 500 Index at 0.18%. Comparing the relative size of the two funds provides a reasonable explanation for the difference in annual expenses, but why accept a 0.32% drag on return if your husband can convince the employer to provide a lower-cost option?

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