If you receive a regular paycheck, then what you earn is what you get. Your take-home pay typically doesn’t change week to week or month to month unless you receive a pay hike or cut or change your withholdings.
But if equity compensation is added to your earnings, things get more interesting. Equity compensation can boost your earnings considerably, but it comes with complex conditions and tax implications, so you want to be sure you know how it works.
Here is a general overview. For specifics, contact your plan administrator, financial advisor, and/or accountant.
Also a good idea: Plan to attend our upcoming webinar, “A Money Guide for Tech Professionals” in early March, watch for our announcement!
What is equity compensation?
Equity compensation is non-cash pay offered to employees. It’s typically provided as a retention or productivity incentive by established companies or as alternative compensation by start-ups that may lack cash or prefer to invest cash into growth activities.
The most common types of equity compensation include non-qualified stock options (NSOs), Incentive Stock Options (ISOs), and restricted stock. Each of these represents ownership in the firm.
Although specifics vary, each equity compensation essentially offers the same premise:
Employees may purchase shares of the company’s stock at a predetermined price and future date.
If the fair market value of these shares at that time is higher than the purchase price, a subsequent sale can net a potentially lucrative profit. That’s one reason why stock options are considered sought-after benefits.
The equity compensation lingo you should know
While stock options are beneficial, they’re not necessarily simple to understand. Most contracts governing employee stock options spell out various key terms and conditions that you need to know:
- Vesting schedule: The time when your options or shares become available for you to buy. Keep in mind that you’ll rarely receive all your options at once. There are two types of vesting schedules to understand:
- Cliff vesting: A waiting period, such as one year, you have to stay employed with the company before any of your options even begin to vest. If your employment terminates before the end of this waiting period, you’re likely to forfeit all options.
- Graduated vesting: A set number of shares that become vested over time, e.g., four years. For example, only one-quarter of your stock options may vest after one year. That means that all your stock options vest after a full four years.
- Grant date: The date when your options are available.
- To exercise: To buy the options you have been granted by the company.
- The exercise price (or grant price): The price at which you may purchase the company shares in the future, no matter the stock’s trading price on that day. Often, but not always, the exercise price reflects the fair market value of the stock on the grant date.
- Holding period: How long the investment is held before the sale.
- Expiration date: The last day of the option’s life cycle. A common option term is 10 years, assuming you remain an active employee of the company. Separation from employment typically shortens the expiration dates, e.g., if you resign, you may have only 90 days following your last day of employment to exercise any outstanding, vested options.
Let’s look at an example:
You start a new job and your employer grants you 10,000 company shares at an exercise price of $10 over a four-year vesting period with a one-year cliff.
On the first anniversary of the grant date, you are eligible to exercise/buy (and subsequently sell) up to one-quarter of the shares, i.e., 2,500. You don’t have to exercise any at all or you may exercise fewer than 2,500 shares. Hence, the label “option.”
If the current stock price is $40. If you do buy and then sell all 2,500 shares, you’d make a gross profit of $75,000 (2,500 x 40 – 2,500 x 10), minus any fees, commissions, and taxes. (More about those in a moment.)
Incidentally, many companies will let you buy and sell seamlessly by advancing the purchase cost so you don’t have to come up with the initial cash outlay.
One more concept you need to understand is a blackout period. It refers to a period when employees are prohibited from buying or selling shares (or making changes to the company plan investments). This is a SEC rule designed to protect employees, as well as investors in the open market, from insider trading.
Blackout periods may occur each quarter before the release of earnings reports. Other triggers may include the release of new products, mergers, and acquisitions or an initial public offering.
Just as there are different types of options, there are different tax implications.
Again, the following is a quick summary. For details, consult with your tax advisor, plan administrator, or financial planner.
Non-qualified stock options: NSOs are available to employees of the company, as well as advisors and consultants. Two types of taxes apply:
- Ordinary income taxes when the options are exercised. The difference between the grant price and the fair market value of the share when the options are exercised is subject to ordinary income taxes that year.
- Short- or long-term capital gains taxes must be paid on any profit made from the sale of the shares.
Incentive stock options: ISOs are only available to employees of the company, not outside directors or consultants. They offer greater tax advantages because exercising the options is not considered a taxable event.
Instead, capital gains taxes—short- or long-term depending on how long the shares were held—apply, based on the difference between the market price and the exercise price. Higher-earning employees may have to pay an alternative minimum tax (AMT).
Restricted stock and RSUs
Restricted stock and restricted stock units (RSUs): Restricted stock is considered unregistered shares of a company and are often granted to executives and other senior-level employees.
RSUs, on the other hand, are an unsecured promise of stock and are issued only once vesting and forfeiture requirements have been satisfied, which is also when they become subject to ordinary income taxation.
If you hold RSUs, you might want to consider setting up auto sales to lessen tax liabilities. You may have to pay taxes when the stocks vest and again after the sale.
Exercising stock options – how good is it for your financial health?
Exercising your stock options comes with many considerations. By selling your company stock options, you will not only benefit from the financial gains—assuming there are any—but you will also reduce your risk of over-concentration of one particular equity.
Always heed “diversification,” the mantra of successful investing. You should never put all your proverbial eggs in one basket.
That holds true for company stock—even if it’s soaring.
It’s a good idea to limit a specific company to no more than 10-15 percent of your portfolio so you don’t tie up too much of your wealth in a single investment. This strategy will cushion your assets from excess volatility.
Remember that your 401(k) or profit-sharing match, if you receive either one, oftan contains company stock. Add it all up. How much company stock do you own in total? Consider rebalancing as appropriate.
Lean on Your Goals
As you contemplate the purchase and sale of company stock options, think about how they tie in with your top financial goals. How would the cash gain help accomplish any of them? Would you be able to pay off your student loans or make a down payment for a house?
For one client, his company stock option proved to be a major windfall. He sold it at a considerable profit, which he used to pay off a large portion of his mortgage. With that liability now almost paid off, he and his spouse were then in the position to consider working part-time and spending more time with their family, something that wasn’t possible a year ago.
What freedoms would financial independence bring to you?
Ready to get into the game?
Employee stock options can be valuable additions to your portfolio should they be offered to you.
But because they are complex, you need to know exactly what they’re all about.
We invite you to learn more at our upcoming tech-focused webinar where we will focus on smart money moves for tech professionals. We will be holding an in-depth webinar completely dedicated to financial planning for tech pros. Please watch for our upcoming announcement! We hope to see you there! For any other financial needs, feel free to reach out to us today.