Equity compensation is often a significant part of many executives’ pay packages, designed to align their financial interests with the company’s long-term success. However, the world of equity compensation can be complex to navigate, with various forms of compensation, tax implications, and strategies to consider. Below is a guide to the most common types, including the differences between restricted stock and restricted stock units (RSUs) and some smart ways to handle each.
Stock Options
The Basics: Stock options differ from other types of executive compensation because they might not have value unless the stock’s current price is trading above the option’s “strike” price, or the price that the option allows you to buy the stock. Two types of options are offered, and each has different tax consequences.
- Incentive Stock Options (ISOs): Typically offered to employees, ISOs come with attractive tax perks. If you plan effectively, gains on ISOs can be taxed at a lower capital gains rate instead of ordinary income tax rates.
- Non-Qualified Stock Options (NSOs): These are more common and can be given to employees, directors, and others. Unlike ISOs, NSOs are taxed as ordinary income when you exercise them.
What You Can Do:
- Time Your Exercise: With ISOs, timing is everything. If you hold onto the stock for at least a year after exercising and two years from the grant date, you could lower your tax bill by qualifying for long-term capital gains treatment. Ordinary income tax rates top out at 37%, and the highest capital gains tax rate is 20% (not including the additional 3.8% Medicare surtax), so the tax savings could be substantial.
- Watch Out for AMT!: Exercising ISOs can trigger the Alternative Minimum Tax (AMT). Knowing where you stand with AMT is important before deciding when and how much to exercise.
- Hedge Your Bets: If you plan on holding the stock after exercising your options, you may want to consider hedging strategies like protective puts or collars to protect against a drop in stock value.
Restricted Stock
The Basics: Restricted stock gives you real company shares, but they come with restrictions, just as the name suggests. You don’t have full ownership until they vest, which usually requires you to stay with the company for a “vesting” period or hit performance targets.
What You Can Do:
- Consider the 83(b) Election: This allows you to pay taxes on the stock’s value when it’s granted, which could save you money if the stock goes up before it vests. If you expect the stock to appreciate, it could be a smart way to lock in a lower tax bill upfront. Just be sure you’re comfortable with the risk—you’ll pay taxes even if the stock never vests.
- Prepare for Tax Day: If you don’t go the 83(b) route, you’ll owe taxes when the shares vest, based on their value at that time. Planning for this can help you avoid a surprise tax bill. It is also common for companies to under withhold taxes, so it is important to coordinate your stock vesting with your accountant.
- Diversify, Diversify, Diversify: Once your restricted stock vests, consider selling some or all your shares to diversify your portfolio, especially if you already have much of your wealth tied up in company stock. We often tell clients to treat restricted stock like a cash bonus. If you received this compensation as cash and wouldn’t buy your company’s stock with it, it often makes sense to sell the stock immediately and diversify.
Restricted Stock Units (RSUs)
The Basics: RSUs are a promise of company shares, but you don’t get them until you meet the vesting requirements, which are usually based on time or performance.
What You Can Do:
- Plan for Taxes: Since RSUs are taxed as ordinary income when they vest, it’s important to plan ahead. Many executives choose to sell a portion of their shares immediately to cover the tax bill. However, as mentioned above, the number of shares sold is not always enough to cover the tax bill, so it is important to ensure your accountant knows when RSUs are vesting.
- Diversify Your Holdings: Like with restricted stock, once your RSUs vest, you may want to sell some or all your shares to reduce your concentration in company stock and spread your risk.
How Restricted Stock is Different from RSUs:
- Ownership: With restricted stock, you own the shares from day one when you are officially granted the shares (although they can be taken away if you leave before they vest). RSUs, on the other hand, don’t give you ownership until the vesting period is complete.
- Tax Options: One of the big advantages of restricted stock is the option to make an 83(b) election. RSUs do not allow for an 83(b) election.
Performance Shares
The Basics: Performance shares are similar to RSUs but with a catch: You only get them if the company hits certain performance targets, like revenue goals, profitability, or stock price milestones.
What You Can Do:
- Keep an Eye on Metrics: Stay informed about how the company is performing relative to the performance targets. This can give you a better sense of whether those shares will likely be paid to you.
- Be Ready for Different Outcomes: Performance shares are contingent, so it’s smart to plan for different scenarios, depending on whether the company meets those targets.
- Diversify After Vesting: If you receive performance shares, consider selling some to diversify your holdings, especially if the shares were earned based on short-term performance.
Employee Stock Purchase Plans (ESPPs)
The Basics: ESPPs let you buy company stock at a discount, often up to 15%. During an offering period, you contribute funds, which are then used to buy stock at a discounted rate.
What You Can Do:
- Max Out the Discount: If you can afford it, participate fully in the ESPP to take advantage of the discount. It’s essentially free money. Sometimes, there is not only a discount but also a “lookback” provision, meaning you could buy the stock for what it was trading at a certain date or period of time in the past.
- Hold for Tax Advantages: To get favorable tax treatment, consider holding the stock for at least one year after purchase and two years from the start of the offering period.
- Avoid Over-Concentration: It’s easy to let company stock take up a big chunk of your portfolio, especially with ESPPs. Regularly check to ensure you’re not too heavily invested in your company’s stock, which can be risky.
Equity compensation can be a powerful tool for building wealth but requires careful planning. One of the common mistakes many executives make is having too much of their finances tied up in a single company, which is why diversification is so important. Additionally, understanding the nuances between different forms and knowing when to exercise options or sell shares can make a big difference in your financial future. Working with a CERTIFIED FINANCIAL PLANNER™ professional to navigate these decisions can help ensure you make the most of your equity compensation and stay on track with your long-term financial goals.
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