If you're a young professional, chances are you've encountered some form of equity compensation from your employer, whether through Restricted Stock Units (RSUs), Incentive Stock Options (ISOs), Non-Qualified Stock Options (NSOs), or an Employee Stock Purchase Plan (ESPP). Equity compensation is a great way to build wealth, but it can also be confusing, especially when it comes to taxes and planning strategies.
In this blog, we'll break down the basics of how each type of equity compensation works, how it's taxed, and how you can plan for each to make the most of these opportunities.
Restricted Stock Units (RSUs)
How They Work: RSUs are essentially a promise to give you company stock after a vesting period. You don’t need to pay anything to receive the shares—they’re granted to you as part of your compensation package. Once received they're treated the same way as a cash bonus.
Example: Let’s say you’re granted 1,000 RSUs that vest over four years, with 250 shares vesting each year. Once the shares vest, you own them, and the value is considered taxable income.
How They're Taxed: RSUs are taxed as ordinary income when they vest, based on the stock's value at that time. For example, if 250 shares vest when the stock is worth $50 per share, you’ll be taxed on $12,500 in that year.
Planning Tip: Since RSUs are taxed as ordinary income, you will pay taxes on them, especially if the company doesn’t automatically withhold enough. Depending on your situation it may make sense to immediately sell them and diversify into other savings vehicles.
Non-Qualified Stock Options (NSOs)
How They Work: NSOs give you the option to buy company stock at a set price, called the strike price, after a certain period of time or once certain conditions are met.
Example: You’re granted the option to buy 1,000 shares at a $20 strike price. A few years later, the stock price rises to $50. You exercise the option, buying the stock for $20,000, even though it’s worth $50,000, immediately giving you a $30,000 gain.
How They're Taxed: NSOs are taxed at two points: first when you exercise the option, and second when you sell the stock. The difference between your strike price and the market price at exercise is considered ordinary income. Any future gain when you sell the stock is subject to capital gains tax.
Planning Tip: Timing matters when exercising NSOs. It’s important to be mindful of the tax impact of exercising, especially if you’re planning to hold the stock for a long period. A smart strategy can help reduce your overall tax burden.
Incentive Stock Options (ISOs)
How They Work: ISOs are similar to NSOs but come with the potential for more favorable tax treatment if you meet certain holding requirements.
Example: You’re granted the option to buy 500 shares at a $10 strike price. A few years later, the stock price is $40. You exercise your options and buy the shares for $5,000. If you hold onto them for at least one year after exercising and two years from the date of the grant, any future gain is taxed at the long-term capital gains rate.
How They're Taxed: ISOs offer the potential for long-term capital gains tax treatment if you hold the shares for the required period. However, the Alternative Minimum Tax (AMT) may apply when you exercise if the spread between the strike price and the market price is significant.
83(b) Election: If you expect your company’s stock to increase significantly, consider making an 83(b) election when you exercise ISOs. This allows you to pay taxes early, based on the stock’s value at the time of exercise, which could save you from a larger tax bill later on.
Planning Tip: The 83(b) election can be a useful strategy for reducing your tax burden in the future, but it comes with risk. Be sure to consult with a financial advisor to determine if it’s right for you.
Employee Stock Purchase Plans (ESPPs)
How They Work: An ESPP allows you to buy company stock at a discount (often up to 15%) through payroll deductions. Many ESPPs include a lookback provision, which means the purchase price is based on the lower of the stock price at the start or end of the offering period. This provision ensures you’re buying stock at the best possible price, making ESPPs a great deal.
Example: Imagine your company offers a 15% discount, and you’ve contributed $5,000 over a six-month period. If the stock was priced at $50 at the start and $60 at the end of the period, the lookback provision allows you to buy the stock based on the lower $50 price. With the discount, you’re effectively buying shares at $42.50, while they’re worth $60. You’re immediately up on your investment (that's a guaranteed 17.6% return). This makes an ESPP a no brainer for most.
How They're Taxed: You aren’t taxed when you purchase shares through an ESPP, but you will be when you sell them. If you hold the shares for more than one year from the purchase date and two years from the offering date, you’ll qualify for favorable long-term capital gains treatment. Otherwise, any discount you received will be taxed as ordinary income.
Planning Tip: Given the lookback provision and guaranteed discount, ESPPs are often a no-brainer. One common strategy is to max out your ESPP contributions, then immediately sell the shares at a profit and diversify the proceeds into a taxable brokerage account or other savings vehicles.
Equity Compensation Decision-Making Matrix
When it comes to planning around your equity compensation, it's important to balance various factors like liquidity, diversification, personal goals, and cash flow. Use this table as a guide to help you make more informed decisions:
Factor | Considerations | What to Do |
Concentration in Company Stock | Are you holding too much of your net worth in one company's stock? High concentration increases risk, especially if your employer is your main income source. | Diversify by selling shares regularly and investing in other assets to reduce your reliance on one company’s performance. |
Liquidity | Do you need cash in the near term? Equity compensation might tie up wealth in illiquid stock. | If you need liquidity, consider selling vested RSUs or exercising stock options and selling right away. |
Personal Goals | How do your financial goals (like buying a home, paying off debt, or starting a business) align with your equity compensation strategy? | Align your equity strategy with your broader financial goals, factoring in risk tolerance and time horizon.(that's what we do!) |
Cash Flow | Will exercising stock options or holding company stock impact your cash flow, especially when taxes are involved? | Plan for tax obligations from RSU vesting or option exercises, and make sure you have enough cash to cover tax payments. |
Tax Planning | Do you want to minimize taxes on your stock gains? Holding stock longer can lead to lower capital gains tax rates, but it increases market risk. | Consider strategies like the 83(b) election for ISOs or selling ESPP shares quickly to lock in gains and diversify. |
Risk Tolerance | How comfortable are you with the risk of your company’s stock fluctuating in value? | Balance your risk by determining how much company stock you’re willing to hold relative to your overall portfolio. |
Conclusion
Equity compensation can be a powerful tool for building wealth, but it’s essential to understand how each type works and how it’s taxed. Whether you have RSUs, NSOs, ISOs, or ESPPs, each comes with its own set of rules and tax implications. While the examples we've provided here are basic, they give you a general idea of how these equity compensation plans operate.
At WealthBound Advisors, we specialize in helping young professionals navigate complex financial topics like equity compensation. If you need help creating a personalized strategy that fits your financial goals, reach out to us here. We're here to help you make the most of your equity compensation and other wealth-building opportunities.
Disclaimer: None of this should be seen as advice. This is all for informational purposes. Consult your legal, tax, and financial team before making any changes to your financial plan.: