Stock options are often a key part of a compensation package, and when things are going well for your company, they can boost your total income appreciably.
But options can be complex, and disentangling this complexity can be a key part of maximizing your income.
So what do you need to understand about your stock options to ensure you’re making the most of them?
Understanding Your Stock Options
There are two key factors when it comes to stock options and taxes:
- When they vest
- How they’re taxed
While stock option windfalls can add a significant surplus to your balance sheet, you must adequately plan for your tax responsibilities to make the most of this opportunity. If you don’t, you may not be prepared when the time comes. Worse, you could end up paying more than necessary to the government.
So when would you get a stock option windfall?
Anything that accelerates your vesting schedule or leads to a jump in share price can lead to a windfall. Accelerated vesting isn’t unusual when companies are acquired or complete an IPO. Management may also decide to accelerate vesting if compensation becomes an issue. As for a jump in share price, merger or acquisition announcements often drive prices higher.
Regardless of the reason for the windfall, putting together a plan can help maximize the value to you. Here’s what you need to know to find out.
Know Your Vesting Schedule and Exercise Plan
Be sure you know the specific type of equity compensation you have, whether that’s stock options, RSUs, or some other type of equity grant.
Because each type of equity is treated differently from a vesting, exercising, and tax perspective.
Let’s start with a vesting schedule.
Equity Vesting Schedule
Do you know your vesting schedule? Or even what a vesting schedule is? If not, you need to. In fact, you must to plan effectively. Your vesting schedule determines what you can do with your options and when you owe taxes.
Every vesting schedule is different, but in any case, the vesting schedule spells out when the options are exercisable or when the stock becomes yours.
For example, your company may grant you 2,000 options that vest over 4 years, so 500 options vest each year. In this case, you can exercise up to 500 of them per year that you remain with the company until you have exercised all 2,000.
When and How Much Should You Exercise?
Next, you’ll want to consider the following question,
How many of your stock options are vesting at one time, do they have value (i.e. they’re “in the money”), and what’s the plan for exercising them?
With RSUs, you automatically own the shares as soon as they vest. It’s beneficial because it alleviates the need for a complicated analysis about whether you should exercise. Since it’s automatic, there’s no choice! It also means you don’t have to spend money to “buy” the shares. But with one exception, there isn’t much you can do to reduce your tax burden—more on that in the next section.
However, when it comes to options such as ISOs and NSOs, you have the opportunity to purchase them once they vest. That means you’ll need first to decide if you want to purchase them, and if you do, come up with the money to do so.
How much can you realistically afford to exercise? That will depend on your budget and your exercise price. You may be able to afford to exercise everything you want to, or you may need to wait to avoid excessively restricting your cash flow.
Equity Tax Overview
No equity compensation strategy is complete without thinking about taxes. Unfortunately, taxes and equity can get confusing, especially given how many types of equity you could have at once.
Let’s quickly break down some tax rules for the most common types of equity compensation.
Incentive stock options allow you to buy shares of your company stock and provide an opportunity for tax savings.
When you eventually sell the shares through a qualifying disposition (meaning you sell the shares at least two years after the options were granted and one year after you exercise them), you only owe tax at the long-term capital gain rate for the difference between your exercise price and the current price at the time you exercised. This difference is called the bargain element.
The bargain element is subject to the alternative minimum tax, so you must determine if AMT applies to you.
Any additional gain you receive by holding the stock is taxed appropriately as a long-term or short-term capital gain.
Nonqualified stock options do not provide the same tax advantages as ISOs. With NSOs, the bargain element is taxed as income when you exercise. If you decide to hold the shares, any additional gain is taxed at the appropriate long or short-term rate.
RSUs are arguably the simplest form to understand in terms of how they work and are taxed.
Restricted Stock Units are shares of stock that simply become yours when they vest. Once they vest, you can sell them or continue to hold them. As for taxation, you owe income tax on the value of the shares when they vest (whether you sell them or not), although you *can* choose to be taxed on the fair market value when they are granted using what’s referred to as an 83-b election.. This is a riskier proposition since the shares could drop in value by the time they vest, but it could also save a good bit in taxes if the shares appreciate sharply between grant and vest dates. In any event, you’ll want to do a careful analysis if you’re considering an 83-b election.
Assuming you go the more common route of having your RSUs taxed when they vest, your company will withhold some taxes (up to 22%) when they vest, but that may fall short of what you actually owe. If you’re in a higher tax bracket, you’ll want to set aside some money to cover the difference.
Ultimately, the key is to understand how your equity compensation will be taxed, whether there are any steps you can take to reduce the tax, and what you’ll ultimately net from the grant. Once that’s done, you can move to planning for how best to use the funds to meet your financial goals. A few common uses include:
- Shoring up your emergency fund
- Funding near-term goals like a home renovation or buying a car
- Adding to education funds for your kids
- Maxing out retirement accounts.
- Adding to your investments.
When you have a plan laid out from beginning to end before it’s time to execute, you set yourself up for success. That means thinking now about what you’ll do when your company has an IPO, acquisition, your shares vest, or some other significant liquidity event.
Long-Term Planning for Equity Compensation
If this article has piqued your curiosity in equity compensation planning—good! Equity windfalls are exciting but require planning if you want to get the most value possible.
It can be complex and sometimes confusing, especially when you have multiple types of equity, as is often the case. Work with a professional to guide you through it. We would be glad to help.
Set up a time to talk with our team today.