Stock options from your company can represent an opportunity to build significant wealth over your career; but there are complexities based on the type of grant and your personal situation which require careful planning so you can maximize the benefit.
Let’s start with the basics.
Simply put, granting stock grants or options enables you to share in the growth of a company's value without risking your money until you exercise the options to buy the shares. Stock options are not taxed at grant; rather, you pay taxes only when you exercise the options and/or sell the underlying stock. Example: You receive a grant of 1,000 stock options with an exercise price equal to the market price on the date of grant. You have a ten-year vesting schedule in which to exercise your options to obtain ownership of the 1,000 shares of stock. So as your options vest, you have the right to buy the stock at the exercise price specified in the grant; and all the gain between the exercise price and the current market value is profit to you. Your stock plan document will detail procedures.
Two Kinds of Stock Options
Companies grant two kinds of stock options:
- Nonqualified Stock Options (NQSOs) are the most common type of stock option. When you exercise in-the-money stock options, the difference between the exercise price and the market value is going to be taxable W-2 income to you, at ordinary income tax levels plus Social Security and Medicare taxes.
- Incentive Stock Options (ISOs) offer tax benefits: after you exercise the options, if you hold the stock for at least two years from the date of grant and one year from the date of exercise, you receive favorable long-term capital gains tax treatment for all appreciation over the exercise price. But caution! Don't overlook the significant impact that ISO exercises and sales may have upon calculations of alternative minimum tax (AMT); failure to plan for this can result in a shock come tax-time.
Restricted Stock and RSUs
The stock-market volatility and economic fluctuations of recent years have changed corporate stock grant practices toward granting restricted stock instead of or along with stock options. Although "underwater" options (where the market value when you want to exercise is less than the exercise price) have little practical value to you, stock options give you more leverage in a rising market than restricted stock does. On the other hand, if your company pays dividends, an advantage in restricted stock is that it may pay them on your restricted shares.
Restricted stock is a popular alternative to stock options, particularly for executives, due to favorable accounting rules and income tax treatment. Restricted stock is often used as a form of employee compensation, in which case it typically becomes transferrable ("vests") upon the satisfaction of certain conditions, such as continued employment for a period of time and sometimes the achievement of particular earnings per share goals or other financial targets. Because restricted stock has full value at vesting, companies grant fewer shares of restricted stock than stock options. Restricted stock always has some value to you even when the stock price drops below the price on grant date. This may help you feel more of the wealth impact (and shareholder pain) of rises and falls in your stock price.
Alert: While the decision to exercise stock options lets you choose when you will pay taxes, with restricted stock you cannot control the timing of taxation in the same way. Therefore, it is important to understand the tax treatment and the withholding methods.
Restricted stock units (RSUs) have become the most popular alternative to stock options at many companies. You are more likely to receive RSUs than restricted stock. RSUs involve a promise by the employer to grant restricted stock at a specified point in the future, with the general intention of delaying the recognition of income to the employee while maintaining the advantageous accounting treatment of restricted stock.
Importance of Planning Many companies use a variety of grants, including both stock options and restricted stock units (RSUs) in tandem. It is very important to integrate your various types of stock grants into your overall financial, tax and estate plan. You need to constantly monitor your exercise choices, option terms and tax consequences of your grants in order to avoid falling into a tax trap and to maximize the benefit your company has provided to you.
If you would like to speak with Darrow Wealth Management to help you understand and manage a stock option and/or restricted stock grant or to discuss your overall financial planning and wealth management, please contact us.