We’ve touched on the basics of employment-based stockA financial instrument giving the holder a proportion of the ownership and earnings of a company. options in the past. There are several different types of options, including Incentive StockA financial instrument giving the holder a proportion of the ownership and earnings of a company. Options (ISOs), Non-Qualified Stock Options (NSOs) and Restricted Stock Units (RSUs). Ensuring you get the most out of each may require different strategies. A tax professional can help you work out what’s best for your individual situation, but here are four tips to help you get started:
- Review Your Stock Plan. Documentation on your company’s stock plan should be provided to you by your firm’s compliance department. Keep this handy. It will give you (and your adviser) vital information about what type of compensation you’re receiving, when it’s granted, when it starts vesting and how often they’ll vest.
- Know the Potential Tax Snares. You generally do not owe taxes when you’re initially granted options (ISOs or NSOs). From there, things get a little more complex:
- ISOs that are granted, exercised and held for a specific period of time may qualify for favorable long-term capital gains treatment when sold. In most cases, you’ll pay long-term capital gains rate for your ISOs on the difference between the Fair Market Value (FMV—the stock’s share price on an exchange if it’s publicly traded or its estimated value if it’s privately held) at the time of sale and the discounted price for the shares (if the employer grants employees stock options at a lower-than-market price). That long-term rate is capped at 23.8%.
- NSOs don’t enjoy the same tax benefits as ISOs. When you exercise an NSO after it vests, the spread between the option price and the FMV is subject to ordinary income and payroll taxes, even if you haven’t sold the shares. You’ll then also owe capital gains taxes when you do sell.
- RSUs are a little different from ISOs and NSOs. In this case, you don’t have to buy or exercise shares at all—they are given to you as part of your salary. So, when your RSUs vest, they show up on your Form W-2 as income. Often, your company will sell enough shares to cover the income tax owed at your normal withholding rates. If not, you’ll need to increase your withholding to account for the additional income.
- Spread the Wealth to Protect It. There’s an inherent riskThe probability that an investment will decline in value in the short term, along with the magnitude of that decline. Stocks are often considered riskier than bonds because they have a higher probability of losing money, and they tend to lose more than bonds when they do decline. in holding too much of one security, especially when your wages are also tied to the fortunes of the same company. In other words, remember to diversify. We advise clients to limit company shares to 5% of their overall portfolio assets while also keeping an eye on their tax liabilityLiabilities are calculated by adding up your existing debts (mortgage, car loans, student loans, credit cards, etc.)..
- Know Your Deadlines. Timing matters when you decide to sell your equityThe amount of money that would be returned to shareholders if a company’s assets were sold off and all its debt repaid. compensation. A public company, or one hoping to go public, may restrict when you can sell vested shares to avoid the possibility of insider trading. These “blackout periods” may keep you locked in at a time when you were hoping to sell. Marking blackout dates on your calendar and setting reminders is a great way to keep track of when your shares vest and when they can be sold.
There is no crystal ball that can tell you exactly when to exercise, hold or sell your shares, but having a solid financial plan is the next best thing. As always, we’re here to help. Please loop in your team of investment, tax and planning professionals so we can help you build an options strategy that maximizes your net worth while minimizing your tax liability.