Stock options have become a larger part of our clients’ overall compensation in recent years—but how employers structure their offering varies widely and maximizing the benefit can be tricky.
We’ve touched on the basics of employment-based stock options in the past. There are several different types of options, including Incentive Stock 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 human resources or 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.
Know the potential tax traps. 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 the 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 below 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 risk 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 liability.
Know your deadlines. Timing matters when you decide to sell your equity 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. Mark blackout dates on your calendar and set reminders 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. For more on maximizing equity compensation, check out our podcast on the topic. 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.
This material is distributed for informational purposes only. The investment ideas and opinions contained herein should not be viewed as recommendations or personal investment advice or considered an offer to buy or sell specific securities. Data and statistics contained in this report are obtained from what we believe to be reliable sources; however, their accuracy, completeness or reliability cannot be guaranteed.
Our statements and opinions are subject to change without notice and should be considered only as part of a diversified portfolio. You may request a free copy of the firm’s Form ADV Part 2, which describes, among other items, risk factors, strategies, affiliations, services offered and fees charged.
Past performance is not an indication of future returns. Tax, legal and insurance information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice, or as advice on whether to buy or surrender any insurance products. Personalized tax advice and tax return preparation is available through a separate, written engagement agreement with Adviser Investments Tax Solutions. We do not provide legal advice, nor sell insurance products. Always consult a licensed attorney, tax professional or licensed insurance professional regarding your specific legal or tax situation, or insurance needs.
Companies mentioned in this article are not necessarily held in client portfolios and our references to them should not be viewed as a recommendation to buy, sell or hold any of them.
© 2021 Adviser Investments, LLC. All Rights Reserved.
