Wouldn’t it be nice to get a guaranteed 15% in profit whenever you wanted to sell shares of stock you own?

It sounds too good to be true… but with benefits like employee stock purchase plans that can be part of equity compensation packages, this kind of deal can be real.

Employee stock purchase plans, or ESPPs, are vehicles that employees use to purchase shares of company stock. You contribute to the plan through paycheck withholdings (just like 401(k) contributions are withheld from your paycheck). At periodic intervals, the money in your ESPP is used to buy company stock on your behalf.

Once you purchase shares, those are then deposited into a brokerage account. From there, you own these shares outright and you can either sell them or hold them. Making that decision is a planning conversation in and of itself, but before you can get there, you need to decide if participating in an ESPP is right for you or not.

The Benefits of Participating in an ESPP

Every ESPP is different, so you need to check your plan document to verify how the plan that your employer offers will work before you decide if you want to jump in or not. Some key aspects to look for are the benefits they offer.

ESPPs aren’t powerful tools simply because they allow you to buy company stock. Their real advantages lie in features like discounts and lookback provisions.

If your plan offers a discount, that might range between 0 to 15 percent. That means you can purchase company stock at up to a 15 percent discount off the fair market value. If you immediately sell your shares upon purchase, you can sell them at the full market value, which means you lock in a certain amount of profit simply by accessing the ESPP and selling shares from it.

A lookback provision can help you create even more of a profit, if your plan allows you to buy shares at the price of the stock at the beginning of the offering period or at the end of the purchase period, whichever is better.

While these can provide great reasons for participating in an ESPP, it’s not all upside. ESPPs do come with some limitations and potential issues which you must understand before you decide if contributing to a plan is right for you.

There’s No Such Thing as a Free Lunch… or Free Gains

Say your ESPP offers a 15 percent discount. While that can feel the same as locking in a 15 percent gain on your contribution, the reality looks a little different.

If you buy and sell your stock within one year of the date you made the purchase, you will owe taxes on the gain at your ordinary income tax rate. That could be as high as 40% in some states.

Your 15 percent gain is more like a 9 percent net return. Of course, that’s not bad by any means. But, it’s something you must be aware of in order to properly manage the tax implications of using an ESPP.

Failing to take into account how profits will impact your tax bill can leave you in a bad position when you file next year and realize you owe quite a bit of unexpected money to the IRS.

There is one way to reduce your tax burden, and that is to hang on to company stock you buy through an ESPP for one year or more. You still need to pay taxes, but those might be at preferable, lower long-term capital gains rates.

However, solving one problem with your ESPP can lead you straight into another: additional investment risk thanks to bad market timing.

Holding Shares for Long Periods Exposes You to Risk and Volatility

When you hold an individual stock for any period of time, you expose yourself to more risk and volatility than you would if you kept only a truly diversified portfolio.

Still, many people feel tempted to do just this because they try to avoid the biggest tax rates on the money they could make from selling shares. This forces you to maintain a lot of company stock for an extended period of time… and may take away the advantages of the ESPP, like the lookback provision and discount on shares.

Why? Because there’s no guarantee your company stock rises in value over a yearlong period. Holding the shares means taking on the risk the stock price falls. It could even drop below the price at which you purchased the shares, leaving you “underwater” on the stock.

This is an example of what it can look like when you let the tax tail wag the dog. It’s not always a bad idea to hold company shares… but to do it only because you’re trying to avoid higher taxes doesn’t always make sense.

You need to develop a strategy for how to manage the shares you purchase through an ESPP, and that may require making tradeoffs: like selling immediately and paying more in taxes, but knowing that you received the cash value of your shares right away rather than subjecting them to risk of loss in value over time.

All Your Financial Eggs Might Be in One Basket

The other major downside of an ESPP is that it exposes even more aspects of your financial life to a single entity: your employer.

You already work at the company, which carries risk; all employees run the risk of losing their positions for a multitude of reasons, both within and outside of their personal control.

And, if you have access to an ESPP, you may also have other equity offered as part of your compensation package. That means you might already be exposed to the company stock before you even participate in an employee stock purchase plan.

By contributing to an ESPP, that could increase that exposure to a level that doesn’t make sense for your plan.

ESPPs can offer great advantages, and many employees are right to participate in these plans. But they’re not the best option for everyone, and how you use your plan may require a nuanced approach depending on the context of your current financial situation.

Talk with a financial planner to make sure you’re considering all the angles before you make a decision on whether or not to participate in an ESPP.