Many companies offer equity compensation programs to attract, motivate, and retain top talent while conserving cash and aligning the interests of the employees and shareholders. While these incentive programs provide a great benefit, they must be carefully managed to avoid upsetting your financial strategy or posing a significant tax burden. Below we discuss two of the most common stock option plans that we help our clients understand and maximize.
RSU – Restricted Stock Units
As an employee, you may receive a Restricted Stock Unit (RSU) grant as part of your annual performance assessment or generally as part of your overall compensation package. The majority of RSUs have a vesting schedule, so you don’t receive the full value from the outset (Your employer wants to schedule vesting over a period, rather than all at once, to retain your services!). For example, if your company grants you 400 RSUs, you’ll probably get 100 shares to vest each year (typically on a quarterly schedule) until you vest all 400 shares, at which time you may receive a new grant.
RSUs give you an interest in the company but no actual value until they are vested. Upon vesting, the Fair Market Value (FMV) of the shares is considered income. You will then have the right to sell the vested shares and receive the cash proceeds or hold the shares for a longer period.
Regarding Taxes
Your income will include the FMV of the shares as they vest. You can sell your vested shares and convert them to cash. Alternatively, you may keep the shares, but any gains made after the vesting date would be taxed as capital gains when you sell. If you hold shares and they drop in value, you might be faced with selling those shares at a loss, while paying tax on vesting date FMV you never actually received.
Your employer typically handles your tax withholding at the vesting date by selling enough shares on your behalf to cover the estimated tax liability and distributing the remainder to you. The IRS requires a statutory 22% withholding rate. Because your vested RSUs influence your taxable income, and effective tax bracket, your employer’s tax withholding rate may not be enough.
Strategy
RSUs accrue over time and, if held, can lead to a significantly consolidated position in one firm. An experienced executive might start with 100 shares vested, then 200, then 300, and so on. Suddenly, they discover that a sizable chunk of their holdings, perhaps also a significant percentage of their net worth, consists of company stock.
Accumulation of company stock can lead to more than just lack of portfolio diversification. Generally, having a sizable stock position in the same company that also pays your salary isn’t advisable. If that organization, for a myriad of reasons, experiences a downturn this could have a double-whammy effect.
As a result, it may be advisable to sell all RSUs as they vest. There should be no additional taxes owed, because your costs basis will be the FMV at which you received the stock. In fact, keeping RSUs as they vest is the exact same thing as taking each cash bonus and investing it 100% in your company stock. If you wouldn’t do that, you shouldn’t hold all of your RSUs. By converting the shares to cash you will be better able to manage taxes due and invest proceeds in a more diverse manner. This should provide you with greater and more predictable long-term success.
ISO – Incentive Stock Options
Incentive Stock Options (ISO) are issued by public companies or private companies planning to go public in the future. They are most typically offered to executives and highly valued employees and are designed to encourage these employees to stay with the company over the long term.
An ISO provides an ‘option’ to purchase shares in a company at a set price, called the ‘strike price’, for a specified period. Like RSUs, ISOs are typically subject to a vesting schedule that could be several years. As the ISOs vest, you can exercise them at the strike price stated in the grant. Employees may have 10 years to exercise their options before they expire. Once you exercise vested shares, you now own the shares at the strike price. You may hold them or sell them immediately, but there are several things to consider.
Regarding Taxes
When you exercise your ISOs, you don’t receive any proceeds, as the exercise is only the purchase of the stock. To qualify for the most favorable tax strategy, ISOs need to be held for 2 years from grant date and 1 year after exercise, allowing for Long Term Capital Gains (LTCG) treatment at sale. Pursuing this strategy, however, can trigger what is known as Alternative Minimum Tax, or AMT.
This tax liability is created by the spread, or difference between, the Fair Market Value (FMV) and the Strike price you were granted. This is often referred to as the ‘Bargain Element’, and if large enough, will create AMT. This can be very complex and confusing as many employees are unaware of this and are caught off guard by their sometimes-significant tax liability due to AMT. We help our clients understand the AMT involved with their ISO strategy, and the ways that they can use any excess AMT payments as credits against future taxes in years where they aren’t subject to AMT.
Another option for ISOs is to do a “cashless exercise,” which means you never actually purchase the stock at the strike price, but rather you are simply paid out the spread between the strike price and the current FMV. This is a good choice if you don’t want to worry about AMT, or if you don’t have the cash necessary to buy the shares at the strike price. However, this strategy will cause the spread to be taxed at ordinary income rates instead of capital gains rates, and it effectively forgoes the potential tax benefits offered by ISOs.
Strategy
We generally recommend exercising options as soon as they vest and holding for long term capital gains treatment. Your specific strategy may vary based on your goals, but reducing what could be a concentrated position, and reinvesting the proceeds in a more diverse portfolio can lead to more predictable long-term outcomes.
The Bottom Line:
The most common misconceptions about equity incentive programs relate to taxation and vesting.
- RSU: Taxed immediately upon vesting using the FMV of the vested shares, usually vest over a period of years, and you can sell them as they vest. No tax benefit to holding after they vest.
- ISO: Subject to vesting schedules, may create AMT liability when exercised and held, and must be held for 2 years from grant and 1 year from exercise to apply LTCG. Typically expire after 10 years.
If your employer offers these unique and valuable benefits, don’t let the financial planning overwhelm you. Act today and consult with an experienced financial planner and a tax professional to develop a solid strategy for maximizing your wealth. If we can help you in any way, please don’t hesitate to contact us.
About the Author
Chuck joins Confluence Financial Partners with 13 years of experience in the financial services industry, most recently as Director of Financial Planning at JFS Wealth Advisors. At a fundamental level, Chuck’s passion for financial planning stems from the desire to help clients connect their personal values and purpose with their financial resources.
