By Jason Epps, CFP®, CRPC®
There’s a reason your employer offers you a benefits package; it’s an incentive for you to stay with the company and a reward for your hard work and loyalty. Additionally, if your employer can align your financial well-being with that of the company, it’s a win-win for everyone. One way employers do this is by providing equity compensation in addition to base salary.
Unfortunately, receiving equity isn’t as simple as receiving a paycheck. There are many forms of equity compensation and each one has different rules, benefits, and will have a different role in your overall financial picture. Because Restricted Stock Units (RSUs), Employee Stock Options (ESOs), and Employee Stock Purchase Plans (ESPP) can be complicated, here is an overview of each type and how they work. Our next article will cover how to incorporate your equity compensation into your financial plan.
Employee Stock Options
ESOs are a type of equity compensation plan in which an employee is given the right to purchase shares of the company’s stock at a set price for a set period of time. If the price of the company’s stock rises above the ESO price, a profit can be made by buying stock at the discounted price and then selling it in the open market.
Types of ESOs
There are two types of ESOs that a company can grant: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs).
Incentive Stock Options are the more complicated type of option, generally only offered to key employees and senior management. ISOs can sometimes offer tax advantages over other types of stock options, but with some restrictions. If an employee exercises an ISO and then doesn’t sell the stock until one year after exercising the option and two years after the grant date, the profit will qualify for capital gains tax treatment. Additionally, the exercise of an ISO can potentially subject certain high-income earners to incur liability for alternative minimum tax, so you will need to consult your tax professional to determine if this applies in your case.
Non-Qualified Stock Options are the most common type of option offered by employers, but do not offer the same tax advantages as ISOs. Upon exercising NSOs, the employee pays ordinary income tax on the difference between the exercise price and the current market price (the bargain element). Since ordinary income is taxed at a higher rate than long-term capital gains, this can make NSOs less attractive for individuals with higher income levels, but the simplicity of NSOs allows employers to offer this type of option more broadly. In addition to income taxes, Social Security, and Medicare, taxes will also be withheld when NSOs are exercised.
Restricted Stock Units
RSUs are granted to employees but are subject to a vesting schedule, meaning you can’t benefit from them until a set time determined by your company and the conditions they place on the stock. It is usually time-based, requiring you to remain with the company until becoming fully vested.
Like any form of equity compensation, RSUs have unique tax treatment. Since RSUs are shares granted to an employee as a form of compensation, the shares are taxed at the time of vesting, with the then current market price of the shares taxed as ordinary income. Typically, when RSUs vest, shares are immediately sold to withhold for taxes, similar to a cash bonus. When you hold shares and sell them at a later date, the difference between the sale price and the value on your vesting date will be taxed as a capital gain or loss.
In terms of capital gains tax, the equation is simple. If you hold your RSUs for more than a year after they vest, your gain on the stock will be taxed as a long-term capital gain instead of a short-term capital gain, which are taxed at the same rate as ordinary income.
Employee Stock Purchase Plans
An ESPP is your employer allowing you to purchase company stock, usually at a discounted price. Your employer will make it easy for you by automatically and regularly withdrawing money from your paycheck to finance your purchases of company stock.
There are four phases to the ESPP. In the “grant phase,” the option to purchase is given. During the “offering period,” you accumulate after-tax payroll deductions; then during the “transfer period,” those deductions are used to effectively purchase company stock at a discount of 15% or less. Finally, in the “disposition phase,” you sell your shares and face tax implications. During a given year, the maximum amount of capital an employee can invest in their company stock through their ESPP is capped at $25,000.
ESPPs can get even more complicated because the income from the stock can be considered compensation income (the amount the stock was discounted) and capital gains income (the increase or decrease of the value of the shares). Like the other forms of equity compensation, holding on to the stock for at least 2 years from the offering phase and 1 year from the purchase date will help minimize tax liability.
How Does Equity Compensation Fit Into My Financial Plan?
With such a quick overview of a complex topic, you’re likely wondering what all these rules and terminology mean for your financial future. That’s what we’re going to discuss in our next article. If you have equity compensation and want to discuss how to maximize its potential while minimizing risk, reach out to me at jepps@kfapwg.com or call 571-386-2022 to schedule an appointment.
About Jason
Jason Epps is vice president and private wealth advisor at KFA Private Wealth Group, a registered independent advisory firm founded on the premise of providing sound financial and investment advice. With over 15 years of experience, Jason possesses the unique knowledge and expertise necessary to provide his clients with the most applicable and beneficial financial guidance that helps them find confidence in their financial future. Jason is a CERTIFIED FINANCIAL PLANNER™ practitioner and a Chartered Retirement Planning Counselor℠, CRPC®, and believes that a financial plan is only as strong as the advisor’s understanding of the core values and beliefs of each client. He serves a diverse range of clients, from young accumulators to pre-retirees and retirees, including business owners and professionals in a variety of fields.
Jason is passionate about giving back to his community and volunteers with various organizations in the D.C. metro area. He also has coached youth travel and AAU basketball since 2009. When he’s not working, you can find Jason spending time with friends and family, traveling, trying out new restaurants, and cheering on local D.C. sports teams. To learn more about Jason, connect with him on LinkedIn.
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(1) https://taxfoundation.org/2021-tax-brackets/
