Stock options have become standard for tech industry workers, but understanding equity compensation is neither intuitive nor straightforward, especially regarding your financial goals.
Your company may offer several types of equity, and each one comes with its own benefits and considerations. While it may be tempting to coast on simple decisions, neglecting to steer the wheel can lead to missed opportunities, higher tax obligations, and a concentrated portfolio.
Making your equity compensation work for you now and decades down the line requires dedication. I’ve been in your shoes and have been overwhelmed by these options as well.
Now on the other side, I’m excited to share these five crucial steps to help bring clarity and understanding to your equity compensation.
#1: Know Your Equity Compensation
Before you can build a strategy, you must know the type of equity you have, as each comes with unique rules, tax obligations, and growth potential. Below are four standard equity compensation options that tech employees may encounter today.
Restricted Stock Units (RSU)
RSUs are a promise of company stock. They are “restricted” because you don’t have access to the shares until the vesting date. Vesting schedules are unique to each company and are often performance or time-based.
You can’t use your RSUs until they vest, but that doesn’t mean you can’t make a plan for when they do. Upon vesting, your RSUs are taxed at ordinary income rates, like a cash bonus. If you have any RSUs vesting this year, factor that extra income into your year-end tax plan.
Keep in mind that when your RSUs vest, your company will retain some shares to cover the tax liability. Per the IRS, they are only required to withhold 22%, which may or may not be enough to cover the full tax burden, leaving you with a potentially unexpected bill come April. Look into how much your company withholds and how much cash you may need to have on hand to make up the difference.
Once your RSUs vest, you own shares in your company stock, which you can keep or sell.
Employee Stock Purchase Plans (ESPP)
An ESPP program allows employees to purchase company stock at a discount, usually anywhere from 5-15%. You can invest post-tax dollars directly from your paycheck into a fund from which your employer will draw to purchase company stock. The process is similar to investing in your 401(k).
ESPPs often cycle through 6-month enrollment periods, where employees can enroll and select how much they want to contribute per pay period.
In addition to the discount, many companies have a look back provision, which allows you to purchase the stock at the lowest price throughout the specified purchase period.
You can defer both salary and bonus up to the $25,000 IRS limit. Some companies may impose other restrictions and limitations.
Participating in your ESPP program is an excellent avenue to automate a savings plan. Since you elect to have the funds automatically deducted from your paycheck, you eliminate the temptation to spend that extra money instead of investing it. Doing so promotes more long-term savings habits and helps you actively invest in your future.
With this plan, you’re also purchasing your company’s stock at a discount, which means you’re getting a bargain as well (who doesn’t love a great sale)!
Incentive Stock Option (ISO) + Non-Qualified Stock Options (NQSO)
Both ISOs and NQSOs give employees the right, not the obligation, to purchase a set number of company shares at a predetermined price in the future. Your vesting schedule outlines when you’re eligible to purchase or exercise those shares.
ISOs and NQSOs come with several financial considerations: when and if to exercise, having the cash flow to purchase the shares, making the best purchasing decision for you, when to hold or sell, among several other considerations.
The tax treatment of each option is the most notable difference between the two, which I’ll address below.
#2: Understand Granted vs. Vested
The grant date and the vesting date are two very different events. Generally speaking, the grant date isn’t a taxable event, but the vesting date could be.
What Does “Granted” Mean?
A company can choose to grant equity compensation for several reasons:
- Hiring package for new employees
- Company-wide bonus
- Performance-driven reward
When granted equity compensation, you should receive an agreement or other documentation outlining your company’s stock plan.
This document will provide important information, including:
- Type of equity compensation
- Vesting date
- Award expiration date (if applicable)
- How termination will impact your awards
Granting equity compensation typically doesn’t mean you have immediate access to the assets; that information comes from the vesting schedule.
What Does “Vested” Mean?
Vesting means different things depending on the compensation type. But generally, the vesting date is when you can access your awards.
Every company is different; some may have a time-based schedule like annually or quarterly, whereas others look at performance measures like reaching a money milestone, and others look at your seniority and time with the company.
For example, when restricted stock units vest, the stocks will typically be deposited into a brokerage account minus a portion for taxes.
Once your ISOs or NQSOs vest, you can take action! Nothing occurs automatically (as it would with RSUs), but you have a choice to exercise or not.
#3: Consider Your Tax Obligations
As with most major financial decisions, you need to consider your potential tax obligation carefully.
RSUs: RSUs have two taxable events: at the vesting date and when you sell the shares. When your RSUs vest, you pay ordinary income tax the same way you would with a bonus. When you’re ready to sell, you’re responsible for paying capital gains tax if shares increase in value.
ISOs & NQSOs: It’s important to know that NQSOs have two taxable events: when you exercise the options and when you sell them. There’s always a risk that if you exercise and hold, the stock’s value will decline, meaning you may owe taxes on a value that’s no longer there.
ISOs are only taxable when you sell them. Should you meet specific holding requirements (retaining the asset for over a year), the sale could be taxed at long-term capital gains rates.
If you exercise an ISO before tax time, for example, you could give yourself 12 months to either hold or sell before next tax season.
There is a tax catch when you exercise ISOs. You will need to notate the value of the shares when you exercise for alternative minimum tax (AMT) purposes, but you aren’t on the hook for ordinary income tax in the same way as NQSOs.
ISOs are complicated and should be addressed on an individual basis.
ESPP: Taxes on ESPPs can be tricky, depending on a couple of factors:
- The type of plan you have (Qualified and Nonqualified)
- The type of sale you make on the stock (Qualifying or Disqualifying)
First, you’re responsible for ordinary income tax on the discount percentage in the year your shares vest. Second, you may have to pay capital gains tax (short or long term depending on holding requirements) on any growth when you sell your shares.
Let’s look at your plan together to determine the tax treatment you can expect and strategies to maximize your funds.
#4: Prepare to Take Action
If protecting your short and long-term financial wellbeing is the priority, a willingness to be flexible and nimble with your equity comp options is prudent. When the time is right, be ready to sell, rebalance, and diversify as needed to keep your portfolio well-balanced and tax-conscious.
It is possible to have too much of a good thing, meaning your equity compensation should not account for the majority of your portfolio. Work to keep your company stock at about 10% or less of your net worth as a general consideration. Selling shares and reinvesting are an essential and regular part of keeping your portfolio diversified and on track to address your long-term goals.
#5: Connect With Brightview
The good news is, you don’t have to go through this alone. I’ve worked in the tech industry and have been presented my fair share of confusing equity compensation options. It can be exciting and nerve-wracking all at once.
I’m happy to sit down, review your current portfolio structure, discuss your concerns, and develop a game plan moving forward. Together, we can maximize your stock options while working to minimize stress and confusion.
Please reach out anytime; I look forward to bringing peace of mind to your financial life.