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How Should Equity Compensation Fit Into Your Financial Plan?

Receiving stock options or another type of employer equity as part of your compensation package may feel like a windfall. But whether or not that turns out to be the case could depend on how wisely you manage your grant.

Successfully taking advantage of your equity compensation requires the untangling of a number of questions. To start with, you have to understand what kind of company stock or stock options you’ve received, when they vest, and when and how they’re taxed. Once you determine that, you can determine what your grant is worth—and decide how the stock affects your financial plan, says Robert Aruldoss, senior financial planning research analyst at the Schwab Center for Financial Research.

Know what you own

The first step toward maximizing your equity compensation, Robert says, is to understand what type of equity you have. That will help you establish the terms of ownership and the vesting schedule or other waiting period involved.

One of the most common forms of equity compensation, stock options, offer you just that—the option (but not the obligation) to buy shares in the company. The right to exercise those options usually emerges via a vesting schedule. Once those options have vested, they have value only if the fair market value of the stock is higher than the “exercise price” at which the option allows you to buy the stock. The difference between the list price and exercise price of the option, called the “spread,” represents the amount of money you will make on each option.

Alternatively, you may receive shares of the company outright in the form of restricted stock or restricted stock units (RSUs). A direct transfer of shares may seem simpler than stock options. But it’s important to look at how the structure of each kind of stock grant determines when and how you can cash out your shares.

With restricted stock, the employer grants the stock to the employee upfront, but the employee can sell it only at the end of the vesting period. With RSUs, the employer grants the stock to the employee on a vesting schedule.


Once you understand the type of equity you’ve received, it’s time to consider the taxes. This is especially important, because, as the table above shows, different types of equity compensation can be taxed in very different ways.

Some forms of equity compensation, such as incentive stock options (ISOs), aren’t subject to ordinary income tax when exercised and held for the qualifying period. You must hold shares from ISOs for longer than two years from the grant date and one year from the exercise date for the proceeds to be taxed at the lower capital gains rate, rather than as ordinary income. But ISOs can also trigger the alternative minimum tax (AMT).

The spread on nonqualified stock options (NQSOs) is taxed as ordinary income at the time the options are exercised. Restricted stock is taxed as ordinary income when it vests, and RSUs are taxed as ordinary income when the employer transfers the stock.

Keep in mind that the amount of any required tax withholding won't necessarily be large enough to cover the full amount of tax you ultimately owe. You may still end up owing tax when you file even if you paid withholding, because the withholding amount is essentially an estimate of the actual tax liability.

It is worth noting that with ISOs, NQSOs, restricted stock and RSUs, capital gains tax applies to any gain or loss on stock sales made after the investor takes full possession of the shares. Because the tax implications of equity compensation can be complex, it’s worthwhile to consult a tax professional.

What’s it worth?

Once you’ve figured out how your equity compensation works, and how it will be taxed, you can determine what it’s worth.

“When dealing with restricted stock, the current after-tax fair market value of the restricted shares is a good estimate of its value,” Robert says. “For incentive or non-qualified stock options, you can calculate their after-tax, in-the-money value based on the spread to determine their current value.”

As an example: Imagine you work for a large company and have been granted 10,000 shares of nonqualified stock options with a strike price of $10. If the stock trades for $20, and you’re in a 40% combined marginal income tax bracket (federal/state/FICA), that would leave you with a value of $6 per share. (Note: We’re using an after-tax, intrinsic value calculation for simplicity’s sake.)

Armed with an estimate, you can tackle the bigger question of how to fit that company equity into your overall portfolio and equity allocation.

Stay diversified

Typically, Robert says, for portfolio diversification purposes you should limit the stock of any one company to no more than 10% of your total portfolio. The number is not set in stone (it could be higher, depending on what else is in your portfolio), but it’s important to be aware of the risk of overexposure when managing company equity. If you concentrate more than 20% in company stock, you may expose yourself to more company risk than is wise.

“Company stock is uniquely risky as it is most likely to be down in price when your job itself may be at risk,” Robert cautions.

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Important disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Tax laws are subject to change, either prospectively or retroactively. Individuals should contact their own professional tax advisors or other professionals to help answer questions about specific situations or needs prior to taking any action based upon this information.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.


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