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WHAT I’M THINKING ABOUT:
Options and vesting and taxes, oh my!
Stock options. The words still conjure images of dark-suited executives in mahogany-paneled board rooms. But these days all sorts of people receive equity compensation, from c-suite officers down to new hires at tech companies. And that means there are more and more employees being paid in a form that can be difficult to understand and even harder to manage. That may include you. And so today we’ll go through the basics of employee stock compensation and how to best leverage it to reach your financial goals.
Types of Stock Compensation — Understanding What You Have
Stock compensation is a way employers reward their employees, incentivize them, and encourage them to stay. In today’s hot job market, employee retention is more important than ever for companies.
In providing stock compensation, companies give you either (a) stock in the company, or (b) the opportunity to purchase stock at a certain price or discount. In either case, while the compensation is typically granted during your annual review cycle, you don’t actually receive the benefit immediately. Instead, you gain access to the compensation over time based on a vesting schedule. You are unvested at the time of the grant but become vested on certain dates down the road. If you leave your employer, any unvested grants are typically lost — thus the incentive to stick around.
Those are the broad stokes, but there are many different types and variations of stock compensation. Now we’ll go through the most common types of stock compensation you’re likely to see.
Restricted Stock Units (RSUs)
RSUs are a promise from your employer to give you a certain number of shares of company stock at a certain time in the future. They are by far the most common type of stock compensation I see. There’s a real trend among employers (particularly tech companies) toward RSUs. I love them for their relative simplicity and the fact that the client always sees a financial gain as RSUs vest.
Here’s an example. Let’s say you receive a grant of RSUs on April 1, 2019. The grant is for 500 shares of your employer’s stock. Your RSUs vest over a 5 year period, so you receive 20% (or 100 shares) annually beginning April 1, 2020. When the first 100 shares vest the stock price might be $100, so the value of your 100 shares would be $10,000. You can then keep or sell the stock as you please (though be sure to only sell during your company’s trading windows and to observe any blackout dates). Regardless of the stock price, vested RSUs provide value to the employee.
Quick tip: It often makes sense to sell shares immediately as they vest. Then put the cash toward short-term goals or re-invest it in a diversified portfolio for long-term goals.
Here’s how RSUs are taxed:
Upon vesting: On the day your shares vest, the market value is taxed as ordinary income (and you also pay Social Security and Medicare taxes on this income). In our example, that means you will be taxed on $10,000 of ordinary income. I generally see employers withhold shares on the day of vesting for taxes. This is similar to the way your employer withholds some of your salary for taxes in each paycheck. So while you had 100 shares vest, you may only see 65 shares show up in your brokerage account because 35 shares were withheld for taxes.
Tax tip: Consider whether you need to sell a little bit extra for taxes. For highly compensated individuals with RSUs, I often see insufficient taxes taken out at vesting so I recommend they sell an additional chunk of shares right away (typically no more than 10%) and set aside the cash for their April tax bill.
Upon selling: Once the shares vest you can sell them right away or hold on to them. From this point forward, taxes work just like they do on any other stocks, mutual funds, or ETFs. When you sell, you’ll pay short- or long-term capital gains tax if the value of the stock is higher than it was at vesting. Similarly, you’ll realize a capital loss if the stock worth less when you sell it compared to the day it vested.
Tax tip: If you sell immediately (or as soon as the trading window opens), the value should be the same or very close to the value at vesting, so there’s little or no gain.
Employee Stock Purchase Plan (ESPP)
An ESPP program allows you to purchase employer stock at a discount through payroll deductions. Participation in an ESPP is voluntary. During an enrollment period, you will tell your employer how much of your salary to withhold for the ESPP (the 2019 annual cap is $25k). Then, at a certain date the stock will be purchased on your behalf with the money that was previously withheld. You can then do what you wish with the stock (though again, you must observe trading windows).
Here’s an example. Let’s say your employer’s ESPP allows you to contribute up to 10% of your salary and then purchase employer stock at a 15% discount. Your salary is $120k so you can contribute $12k, which translates to $1,000 withheld per month. On the purchase date (usually every 6 months) your company purchases the stock for you using your withheld funds that have accumulated. While the stock price might be $100, you’d get to buy at $85 (a 15% discount). So the $6k that has been withheld over those 6 months purchases about 71 shares ($6,000 % $85 = 70.6), which has a current market value of $7,059 (70.6 shares x $100 current price = $7,059). That’s an immediate $1,059 gain on paper ($7,059 market value - $6,000 cash to purchase = $1,059).
Some programs will have favorable features, like a lookback provision that allows you to use the lowest stock price as between the beginning and end of a 6-month period. Check your own ESPP for key details like this.
Quick tip: It’s usually a good idea to contribute as much as you can to your ESPP as long as you’re not jeopardizing your monthly cash flow. So if you’re going to contribute $12k to your ESPP this year, you need to be able to manage about $1k less of pre-tax income each month. And, again, it’s often smart to sell shares immediately upon purchase so you can put the cash toward short-term goals or re-invest in a diversified portfolio for long-term goals.
Here’s how ESPPs are taxed:
Upon purchase: The shares are purchased with after-tax dollars withheld from your paycheck, so there’s no additional tax at the time of purchase.
Upon selling: When you sell the shares, you’ll pay taxes on any gains. The tax rules are pretty complicated for ESPPs. The discount is generally taxed as ordinary income and additional gains are taxed as either ordinary income or capital gains depending on how long you hold the stock and when you sell in relation to the ESPP offering period.
Stock Options
Stock options give you the opportunity to purchase a certain number of shares of your employer’s stock during a set time frame at a specific price (called the strike price). The options vest over time according to a vesting schedule, and you can exercise the options (i.e., purchase shares at the strike price) as they vest. There is also an expiration date, so there’s a limited window for you to choose to exercise your options.
The key to stock options is that they only have value if the stock price rises above the strike price. So if you receive stock options with a strike price of $50, but the stock is trading at $40 when the options vest, your option to buy at $50 is of no value to you. You need to wait until the stock prices rises above $50 before this option becomes valuable (and hopefully that happens before the option expires).
Here’s an example where the options would be valuable. Let’s say your company grants you the option to purchase 5,000 shares at a strike price of $80, which vests evenly over a 5-year period. When the first 20% (or 100 shares) vests the stock price is $100. So naturally you’ll exercise the option and purchase $10k worth of stock for $8k ($80 strike price x 100 shares) — an immediate $2k gain on paper (called the bargain element).
The two main types of stock options are incentive stock options (ISOs) and non-qualified stock options (NSOs or NQSOs). They each have their own unique tax rules:
NSOs: When you exercise, the value of the option (the bargain element) is taxed as ordinary income (including Social Security and Medicare taxes). So in the example above, the $2k bargain element is ordinary income. When you eventually sell the 100 shares, any additional gain is taxed as long- or short-term capital gains.
ISOs: When you exercise you don’t pay ordinary income taxes (though there may be an Alternative Minimum Tax adjustment). Only when you ultimately sell your shares do you pay either ordinary income tax (with no Social Security or Medicare tax) and/or capital gains tax depending on how long you held the stock. In general, you need to hold stock for one year after exercise and two years after the grant in order for the entire gain to be long-term capital gains.
And here are some planning considerations to keep in mind for stock options:
Be mindful of cash flow. Stock options can be tricky to plan around because you need to have the cash available to exercise. Sometimes a stock option plan will offer a cashless exercise option, which is a little like a short-term loan. Your brokerage account loans you the cash to exercise and then you sell right away and pay back the loan, and you end up with just the gain (the bargain element) of either cash or shares. If you don’t have a cashless option and you do have stock options you want to exercise in the future, you need to plan in advance and prepare for the large cash outlay (so $8k from our example above).
Plan for taxes. What taxes do you incur as you exercise and sell stock? With the help of a tax professional you can plan ahead. When you exercise NSOs, if taxes aren’t withheld then you need to plan for the tax bill come April either by selling shares to cover the taxes or using cash you already have sitting in the bank. With ISOs, remember that you may be subject to AMT when you exercise and will need to plan for this tax bill.
General Tips for Stock Compensation
Don’t let taxes call the shots. Yes, there are tax benefits to holding stocks longer. I’m all for minimizing taxes, but don’t feel like you have to wait to sell if your high-priority financial goals dictate in favor of selling quickly and taking the cash (and the higher tax bill).
Form a plan and stick to it. Things can get heady when the stock grants start rolling in. If you want to stay invested in your employer stock, decide in advance how much you’re comfortable holding. I recommend not letting your employer stock become more than 5-10% of you investments across all accounts (including your 401k, IRAs, 529s, and taxable brokerage accounts). Make a decision on what makes sense for you, write it down, and stick to it, otherwise you’re likely to end up wildly over-concentrated in your company’s stock. You're already highly exposed to your employer's health as you depend on it for your salary.
Set calendar alerts for important dates, such as when shares vest and when you plan to sell stock.
Find an expert. If you have employer stock compensation of any kind, you’ve likely outgrown TurboTax. Find a CPA with expertise in whatever form of compensation you’re receiving.
Approaching Stock Compensation in Light of Your Financial Goals
How you approach your stock compensation will depend on your financial goals and circumstances. The key question is whether you have high-priority cash needs, such as paying down high-interest debt, building up your emergency savings fund, or making a down payment on a home in the coming year. If you have short-term cash needs that your regular income does not cover, then those needs will drive how you approach and use your stock compensation. On the other hand, if you’re already on track with your financial goals and have healthy emergency savings, then your stock compensation can be viewed entirely with the long-term in mind.
Everyone’s financial circumstances are different, but here are some guidelines on approaching equity compensation.
High-Interest Debt and Emergency Savings
If you carry high-interest debt or do not have an emergency savings fund, these goals take priority and I recommend approaching your employee stock compensation with the goal of increasing your cash and solidifying your financial situation.
RSUs: Sell shares immediately as they vest immediately. Put the cash towards your goals.
ESPP: If you have high-interest credit card debt or little cash on hand, this may mean you can’t afford to participate. Find ways to build margin in your finances so you can more comfortably contribute to your ESPP.
Stock Options: Similarly, unless you have a cashless exercise option, you may not have the available cash to exercise your options.
Other Short-Term Goals
If you have other financial goals that require cash in the next 12-36 months (like making a down payment, making a career change, or taking a big trip), then use your employee stock compensation to boost your cash. Sell shares immediately as they vest (RSUs) or are purchased (ESPPs and stock options). As always, you’ll have to observe trading windows, but the idea is to sell as soon as you can.
Long-Term Goals
With long-term goals such as college savings, retirement, or a home purchase several years down the road, here’s what I generally recommend:
RSUs, ESPP, NSOs: Sell shares immediately (while observing any blackout dates) once they are in your account, and reinvest the cash into a broadly diversified portfolio.
ISOs: Sell once you’re eligible for long-term capital gains tax treatment, and reinvest the cash into a broadly diversified portfolio.
What I’m Reading
Why Don’t Rich People Just Stop Working?
By Alex Williams, The New York Times
Against the backdrop of the wealthy becoming wealthier, this article explores what motivates the rich and successful to continue working so hard. My favorite take comes from author and life-hacker Tim Ferriss:
Once they have no financial need to work — are ‘post-economic,’ as some say in San Francisco — they have trouble shifting into lower gears…. They’re like drag racers who now have to learn to navigate the turns and intersections of neighborhoods at 30 miles per hour…. Without ambitious projects to fill space … there is often a void that makes some of the bigger questions hard to avoid. The things you neglected are no longer drowned out by noise; they are the signal. It’s like facing the Ghost of Christmas Past.
We may not be as fantastically rich as the Zuckerbergs, Musks, and Cooks discussed in this article, but the questions raised about our everyday motivation for our work apply to us all.
Why You Never See Your Friends Anymore
By Judith Shulevitz, The Atlantic
In a similar vein, this article bemoans how longer and unpredictable work hours have chipped away at our shared times of rest:
I’m nostalgic for that atmosphere of repose—the extended family dinners, the spontaneous outings, the neighborly visits…. Sundays are no longer a day of forced noncommerce—everything’s open—or nonproductivity. Even if you aren’t asked to pull a weekend shift, work intrudes upon those once-sacred hours. The previous week’s unfinished business beckons when you open your laptop; urgent emails from a colleague await you in your inbox. A low-level sense of guilt attaches to those stretches of time not spent working.
The author suggests that this has harmed not only our family lives, but our shared civil society as our increasingly atomized existences pave the way for political divisiveness and even tyranny. The potential solutions the author highlights — primarily laws governing work scheduling and disconnecting from email — may or may not be the right answer, but it’s certainly true that our responsibility to ourselves, our families, and our communities to enjoy shared times of rest starts with you and me.
If you’re ready for financial guidance, accountability, and an action plan, check out our one-on-one services or online courses.