Including Equity Compensation in a Financial Plan
When company stock or stock options are part of your compensation package, it can be tempting to treat such assets as a windfall, separate from your main portfolio. However, equity compensation is like any significant source of income—approach it carefully so you can make the most of it. Knowing what kind of stock or options you have, when they vest, and when and how they will be taxed are essential to understating how they fit into your financial plan.
"Equity awards are complicated, so it's important that you have a general understanding of how they work before you decide how to fit them into your financial plan and portfolio," says Chris Kawashima, CFP®, a senior research analyst at the Schwab Center for Financial Research.
Know what you own
Have you been compensated with stock options or company shares? Companies may choose one over the other based on many factors, including the company's own tax and accounting issues and what's likely to work best for employees.
- Stock options are a common form of equity compensation. With them, you have the opportunity—but not the obligation—to buy company stock at a specified exercise price. This form of compensation is typically subject to a vesting schedule dictating when you're allowed to exercise your options. Once vested, stock options will have value only if the current stock price is higher than the exercise price. (If it's not, you wouldn't want to exercise them.) The two main types of options are non-qualified stock options (NQSOs) and incentive stock options (ISOs). It's important to know what type of stock option you have because they are treated differently for taxes. More on that below.
- Companies can also compensate you in the form of restricted stock or restricted stock units (RSUs). Such grants are "restricted" because they have conditions attached, such as length of employment or performance goals, and you generally can't sell or transfer restricted stock or RSUs until vesting or other restriction requirements are met. With restricted stock, you may have voting and dividend rights because the company sets aside actual shares upon the grant. RSUs, on the other hand, are more like a promise to pay out shares or their equivalent value in cash. No shares are set aside upon the grant, so they don't have the same rights to voting or dividends as restricted stock. The structure of the grant will determine when and how you can cash out and how taxes are assessed.
When do you pay taxes?
As suggested, different types of equity compensation can be taxed in very different ways.
Source: Schwab Center for Financial Research
*Basis is generally set by fair market value at option exercise or stock vesting date; the holding period generally begins at exercise/vesting. Dual cost basis (ordinary and AMT) applies to ISO stock in a qualifying disposition. For treatment of basis and holding period under a Section 83(b) election, consult your tax expert.
- NQSOs: You are taxed when you exercise your options. The tax is based on the spread between the stock's fair market value and the exercise price of the option. The value of the spread is treated as compensation and subject to ordinary income and payroll taxes.
- ISOs: You generally aren't taxed until you sell the stock after exercising your options, giving them a potentially more favorable tax treatment than NQSOs. However, you must meet certain requirements to take full advantage. If you hold the stock for more than two years after the date the options were granted and at least one year after exercising them, the spread is taxed at the long-term capital gains rate, which is generally lower than your income tax rate. This is called a qualifying disposition. (Note: If you are subject to the alternative minimum tax (AMT), qualifying dispositions lose some of their tax advantages as the spread could be treated as income in the tax year you exercise your options, potentially leading to additional taxes.)
If you sell before these criteria are met, the spread at the exercise date is taxed as ordinary income, and any gains after the exercise date will be taxed as either a short- or long-term capital gain, depending on the holding period. This is called a disqualifying disposition. - Restricted stock: The value of the stock grant (less the cost basis) is treated as compensation and is subject to ordinary income and payroll taxes—but timing matters. You're allowed to make a so-called section 83(b) election within 30 days of the grant. This notifies the IRS that income tax on the stock should be assessed based on the valuation at the grant date (rather than later, when it vests).
Why would you do this? Once you pay taxes based on the stock's value at the time of the grant, any future gains in the stock's price will be treated as long- or short-term capital gains, depending on the holding period. If you wait until the restricted stock vests to pay taxes, and the stock's price rises, you could end up with a bigger tax bill. Of course, there's also the risk that the stock's price will fall after the grant or if you leave your company before the stock vests, in which case you would have paid more tax than you needed to. The taxes you paid aren't refundable. - RSUs: With RSUs, no shares are issued until shortly after vesting. At that time, the stock's value (less the cost basis) is treated as compensation and is subject to ordinary income and payroll taxes. Any gain after the vesting period is treated as a capital gain.
Additional tax considerations
Most employers will withhold some portion of the value of your equity compensation from your paycheck. However, that withholding will essentially be an estimate of your actual tax liability and may not be enough. You could still end up owing more when you file.
It's also worth reiterating that once you take possession of any shares, capital gains tax (long or short term, depending on the holding period) will generally apply should you end up selling those shares at a higher price.
Finally, because the tax implications of equity compensation can be complex, it's worthwhile to consult a tax professional.
What's it worth?
Knowing what you've got and how it will be taxed will help you determine how to make the most of your equity compensation.
"When dealing with restricted stock, the current fair market value of the restricted shares is a good estimate of the value," Chris says. "For ISOs or NQSOs, you can calculate their value based on the spread, using the current stock price and your exercise price."
For example, say you have an NQSO for 10,000 shares with an exercise price of $10 that is 100% vested. If the stock is trading at $20, and you have to pay a combined 40% in taxes (federal/state/FICA), that would leave you with a value of $6 per share (or $60,000 for those 10,000 shares).
This is based on a relatively simple calculation. Your situation may be different, so consult with a tax professional or financial advisor for additional help.
Stay diversified
It's important to be aware of the risk of overexposure when managing company equity. Typically, the stock of a single company should account for no more than 10% to 20% of your total portfolio. "Holding stock in the company you work for is uniquely risky as it may likely be down in price at a time when your job itself may be most at risk," Chris cautions.
It's possible you could have more, depending on considerations such as your role in the company, selling restrictions, vesting schedule, and your other portfolio holdings. If you're in this position, you may want to discuss how to manage your risk and ensure your portfolio is properly diversified with your financial advisor.
Equity compensation, in any form, is a potential way to participate in your employer's success. But like any other security, it must be carefully managed to keep with your long-term goals and financial plan.