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How Should Equity Compensation Fit Into Your Financial Plan?

Imagine that your employer has granted you stock in the company you work for, or stock options, as part of your compensation package. It will probably feel like a windfall. But like any large source of income, it needs to be carefully managed so that it doesn’t inadvertently upend your tax situation or financial plan.

Successful planning to gain the full underlying value of your equity compensation requires the untangling of a number of questions. To start with, you have to understand what kind of stock or options you’ve received, when they vest, and when and how they will be taxed.

“Once you determine that, you can figure out what your grant is worth and decide how the stock affects your financial plan and portfolio,” says Chris Kawashima, equity compensation financial planner at Charles Schwab.

Know what you own

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 at a certain exercise price. How the options are granted—as non-qualified stock options (NQSOs) or as incentive stock options (ISOs)—can have significant tax implications.

Usually, your vesting schedule will determine how many options you can exercise at a given time. And they will have value only if the current stock price is higher than the exercise price. The difference between the stock price and the 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 in the form of restricted stock or restricted stock units (RSUs). A direct transfer of shares may seem simpler than stock options, but the structure of the stock grant determines when and how you can cash out and how taxes will be assessed. (Employers make decisions about whether to grant ISOs, NQSOs, restricted stock or RSUs based on many factors, including the company’s own tax and accounting issues and what’s likely to work best for employees).

When do you pay taxes?

Equity compensation isn’t simple, and neither are taxes. This chart begins to untangle when and how you can expect to be taxed based on your award type.

  Nonqualified stock options (NQSOs) Incentive stock options (ISOs) Restricted stock Restricted stock units (RSUs)
Granted* Not taxed. Not taxed. Generally not taxed, unless a Section 83(b) election is made, in which case the stock’s value (less cost basis) is treated as compensation and subject to ordinary income taxes, payroll taxes, and withholding. Not taxed.
Vested Not taxed. Not taxed. Stock’s value is treated as compensation and subject to ordinary income taxes, payroll taxes, and withholding (unless grant date was elected). Stock’s value (less cost basis) is treated as compensation and subject to ordinary income taxes, payroll taxes, and withholding.
Exercised Spread is treated as compensation and subject to ordinary income taxes, payroll taxes, and withholding. Spread becomes income for AMT computation purposes and may result in additional tax if you’re subject to AMT. N/A N/A
Sold* Any gain after the exercise date is taxed as a long term or short term capital gain (depending on holding period).

Qualifying disposition - gain is taxed at the long term capital gain rates.

Disqualifying disposition – spread is taxed as ordinary income and any gain after the exercise date will be taxed as a long or short term capital gain (depending on holding period).
Any gain after the vesting date (or grant date if elected) is taxed as a capital gain at the long term or short term capital gains rates (depending on holding period). Any gain after the vesting date is taxed as a capital gain at the long term or short term capital gains rates (depending on holding period).

 

Source: Schwab Center for Financial Research

*Basis is generally set by fair market value at option exercise or stock vesting date; 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.

Once you understand the type of equity award 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.

ISOs aren’t subject to ordinary income tax when exercised if held for the qualifying period (known as a qualifying disposition). You must hold shares from ISOs for longer than two years from the grant date and at least one year from the exercise date for the proceeds to be taxed at the lower capital gains rate rather than as income. Another thing to consider: ISOs can trigger the alternative minimum tax (AMT) in the tax year in which they’re exercised.

With restricted stock, the employer issues the stock at the grant date, but shares are not transferred to the employee until the vesting requirement is fulfilled. With RSUs, no shares are issued until shortly after vesting. This subtle distinction makes it possible for employees who receive restricted stock, to make a so-called section 83(b) election (this has to be done within 30 days of the grant).

By electing 83(b), a person who has been granted the stock is notifying the Internal Revenue Service that income tax on the stock should be assessed based on the valuation at the grant date (rather than later, when it vests). If the stock rises in value, the increase will be taxed as a capital gain, rather than entire value being taxed as income when the stock vests. Of course, there’s the risk that the stock value falls after the grant and you’ve paid a higher tax than you needed to.

While most equity compensation is subject to payroll tax withholding to help cover the tax liability, keep in mind that this won’t necessarily be large enough to cover the full amount of tax you ultimately owe. You may still end up owing when you file, even if you paid withholding, because the withholding amount is essentially an estimate of the actual tax liability.

In addition to the potential capital gains treatment of ISOs mentioned earlier, it is worth noting that with NQSOs, restricted stock, and RSUs, capital gains tax (long or short term, depending on the holding period) 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 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, imagine you work for a large company and have been granted 10,000 shares of nonqualified stock options with an exercise 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. (This is based on a relatively simple after-tax value calculation; there are other methods that a tax professional or financial advisor can help you understand.)

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, Chris says, for portfolio diversification purposes you should limit the stock of any one company to no more than 10% to 20% of your total portfolio. This range is not set in stone, however, and could be higher depending on other considerations, such as your role in the company, selling restrictions, vesting schedule and your other portfolio holdings.

It’s important to be aware of the risk of overexposure when managing company equity. If you have more than 20% in one company’s stock in your portfolio, you may want to discuss how to manage your risk with your financial advisor.

“Holding stock in the company you work for is uniquely risky, as it is most likely to be down in price at a time when your job itself may be at risk,” Chris cautions.
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 in keeping with your long-term goals and financial plan.

What you can do next

  • Learn what the options are worth, as well as the tax implications of exercising them.

  • Find out when your stock awards or stock options vest.

  • Call Schwab at 800-567-2147visit a branch, or find a consultant to address how your equity compensation fits into your plan.

  • Explore Schwab Private Client, your dedicated team to create and adjust a personalized wealth management strategy tailored to your goals.

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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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