According the National Center for Employee Ownership, about 7.2% of employees own stock options, and even more employees have some equity in their employer. Many tech companies offer stock options and restricted stock units as additional compensation to help attract and retain high performing employees.
If your company does well, the upside of stock options and restricted stock units could be enormous. But they’re complicated financial instruments, and if you don’t manage your stock options correctly, you could make an expensive mistake.
What Are Stock Options?
Employee stock options give an employee the ability to buy a certain amount of employer stock at a set price. This price, called the exercise price, is often discounted, or is at least the market price on the day that the stock options were given (“granted”) to the employee. The majority of tech companies in the Bay area offer their employees some kind of employee ownership in the company, and 58% of tech employers believe that employee equity is key to attract and retain talent and encourage work performance.
The employee often has to wait for a certain period of time before using the option to buy the stock at the reduced price. This waiting period is called the vesting schedule. Since the stock can’t actually be bought at this point, it’s called “restricted stock.”
When the employee uses the option to buy the stock (or “exercises” the option), the employee pays the previously determined price. If the company has done well, the stock will be worth more than what the employee will pay for it with the option.
There’s often a time limit to the option. If the employee doesn’t exercise the option by the expiration date, the employee loses the right to buy the stock at the discounted price.
What are Restricted Stock Units?
Restricted stock units (known as RSUs) have a fascinating history, but put simply, a restricted stock unit is a promise by the employer to give restricted stock at some point in the future. RSUs are used in large private companies like Airbnb and Dropbox, that have very high valuations.
In this case, the IRS-required exercise price is so high that employees won’t be right-side up on their options for a very long time. Instead, the company gives restricted stock units, which then gives the employee the restricted stock upon vesting.
Unlike stock options, RSUs always have some value, even when the stock dips below the price on the grant date.
What About Taxes?
There are two common types of stock options: nonqualified stock options (NSOs) and incentive stock options (or ISOs). Each type of stock option is taxed differently.
NSOs are the most common. With NSOs, the employee is taxed on the difference between the market price and the purchase price of the stock (“the spread”) on the date of exercise. The spread is taxed at ordinary income tax rates. If you own NSOs, consider your current tax bracket and your future tax bracket. If you plan to retire next year, waiting a little while will expose you to more risk but also might substantially decrease your tax burden.
Incentive stock options are less common as they are often a part of executive compensation. With ISOs, no income tax is due at the grant date or exercise date. Instead, if held long enough, ISOs are taxed at long term capital gains rates when the stock is sold.
ISOs may also be subject to alternative minimum tax. Tax considerations for ISOs are complex. If you own ISOs, talk with an experienced tax professional to make the most of your stock options while minimizing your tax bill.
If you’ve either purchased or received restricted stock (say, as a part of restricted stock units), you’ll probably benefit from filing an 83(b) election. This form lets you exercise your options before they’ve vested, so you pay a smaller amount of tax if the company skyrockets in value.
If you don’t, and your company continues to rise in value, you’ll be taxed at increasing rates as the stock price continues to rise. The risk is, however, that you’ll pay the tax and that the company will go belly-up before you would have exercised your options.
Make sure to consult a tax professional as soon as possible if you think these situations apply to you. This form has to be completed within thirty days of the grant date.
When Should I Exercise My Options?
It’s a tough question, and there are a number of things to consider. First, check to make sure that your options are actually vested. If not, you’ll have to wait until the vesting period is complete before you can exercise them.
If your stock option is valued for more than the current market price, you’re out of luck. There’s no point in using the stock option if you’re underwater. Next, you’ll want to consider when your options expire to make sure you actually exercise your options within the time period outlined in your option agreement.
Finally, does your portfolio lack diversification due to a large amount of employer stock? It’s easy to think that the company will continue to do well, but you don’t want your entire portfolio (and your job!) concentrated in one company. If you have more than 10% of your portfolio in company stock options, consider exercising them to diversify your portfolio.
How Should I Think of This Money?
Stock options and restricted stock units do offer a unique way to build wealth. If you’re in the right place at the right time, and you properly manage your stock options, it’s possible to make a great deal of money.
But stock options are risky business, and shouldn’t be considered the same as regular stocks. There’s the possibility to end up with nothing. By including stock options as a part of a diverse portfolio, you’ll build wealth while limiting your downside.