Stock options or awards can be quite complex. Whether you're just starting out and looking to understand what stock options are or you're ready to develop a strategy for your equity compensation, the goal of this article is to provide investors with simple explanations to get you started. Employer stock may be a significant part of your net worth, which is why it's so important to partner with professionals who can help you make the right decisions for your individual situation and goals. To maximize the benefit of stock options or awards, you'll need to have an integrated strategy that can help you diversify your investments, while taking into account the tax implications and other financial planning considerations.
Key employee stock option terminology
Throughout this article we will be using a number of terms to explain how stock options and equity awards work:
- Exercise price (or the strike price): The exercise price is the price at which an employee is able to buy shares of employer stock. This price is set in advance and doesn't change.
- Fair market value (or FMV): Fair market value is the price of a share of company stock in the open market, on a public stock exchange if the company is publicly traded. If the company is private, a valuation firm will periodically conduct a FMV analysis. The fair market value of publicly traded shares changes all the time.
- In-the-money: When a stock option is "in-the-money" or "above water" it means the strike price (the price you paid for the shares, or could buy them for if you have not exercised yet) is currently less than the fair market value of the shares. Here's an example: if your exercise price is $5 and the stock is currently trading for $10, that's considered "In-the-money."
- Out-of-the-money: When a stock option is "out-of-the-money" or "underwater," the strike price (again, the price you paid for the shares, or could buy them for if you have not exercised yet) is currently more than the fair market value of the shares. So using the previous example with a $5 exercise price, an option would be "underwater" if the stock was currently trading for $4.
- Vesting schedule: A vesting schedule is provided along with your stock option or equity award agreement and contains information about when you are able to exercise your shares, when you're vested in the shares, the exercise price, and how many shares you are given as options or awards.
What type of employee stock options do you have?
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 tax 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 units (RSUs) aren't stock options - they're equity awards
The difference isn't just semantics either. Unlike stock options - which require the employee to purchase the option at the strike price - RSUs are just given to employees as equity awards, typically upon vesting. So unlike stock options which can become "underwater" if the market price is less than the price you paid when exercising the option (the strike price), restricted stock units will always have some value unless the stock goes to zero. Obviously, at that point, you would have other issues to contend with.
When granted, RSUs have no tax or income implications as they are still considered “unearned.” To earn the shares, employees must meet vesting requirements set forth by the employer. Many public companies will require time-based vesting but could also include other performance-related requirements, like reaching a target stock price. Private companies typically have a time-based vesting requirement in conjunction with an event-based requirement, such as an IPO, funding, or an acquisition for liquidity.
When RSUs vest they become common stock. The value of your equity grant will be determined by the current market value on the vesting date.
How are stock options taxed?
Taxation of incentive stock options (ISOs)
As mentioned earlier, holding ISOs through the end of the calendar year in which you exercised the options can often trigger the alternative minimum tax (AMT). Further, your employer is not required to withhold any amount at exercise or sale to cover your potential income tax liability. So although incentive stock options do have tax benefits if you satisfy the holding period requirements (at least two years from the date of grant and one year from the date of exercise), in many situations it still may not be advantageous to do so; the AMT and the risk the options may become underwater are two driving factors. This infographic has more on the taxation of incentive stock options.
Taxation of non-qualified stock options (NQSOs)
Although NQSOs don't offer any tax benefits, the tax treatment is more straightforward. Also, your employer will withhold some funds for federal income tax purposes. However, this in no way means the automatic withholding is sufficient. Assuming they are not underwater, non-qualified stock options will be taxed at both ordinary income rates and either short-term or long-term capital gains rates. This infographic has more on the taxation of non-qualified stock options.
How restricted stock units (RSUs) are taxed
When vesting occurs for U.S. employees, the value of the stock grant is considered ordinary income for tax purposes. Ordinary income (or W-2 income) is subject to federal, state, and local taxes in addition to Medicare and Social Security (up to the maximum; $127,200 in 2017).
Although many employers will automatically withhold a portion of income to cover some of the tax due some additional tax planning may be required, as the amount may not be sufficient depending on your situation. It is advisable to consider consulting a CPA or other tax professional to determine whether a quarterly tax payment is required to avoid underfunding your tax liability.
Other ways employees own company stock
- Employee stock purchase plan (ESPP): Section 423 employee stock purchase plans allow you to buy shares of your company’s stock, typically at a reduction of 5% to 15% compared to the market price. ESPP accounts are usually funded through regular payroll deductions, up to $25,000 per year. Learn more about employee stock purchase plans and how they are taxed.
- Employer stock in your retirement plan: According to Bloomberg’s ranking of retirement plans, in 2014, one in five of the largest companies in the S&P 500 made 401(k) contributions in company stock. Owning too much company stock in always a risk, but when the shares are in your retirement plan, it can come with devastating effects. While you may not be able to control whether your employer matches in cash or stock, you can control the asset allocation for your contributions.
Can you have too much company stock?
In a word: yes. And most people do. How much you should invest in employee stock options and company stock will depend on your net worth and risk tolerance, but in general, don't tie up more than 10% of your net worth in your employer’s stock. Holding too much of any one stock is a risk; and it is a risk that many investors actually choose to take, whether they intend to or not. This article has more on why putting too many eggs in one basket and over-investing in company stock can be a bad idea.
Managing concentrated stock positions and how to diversify
Your specific course of action to diversify out of a concentrated stock position will depend on your individual situation, stock agreement, and other terms of your employment. However, in general terms, there are a number of ways that employees reduce their overall holdings in employer stock:
- If your compensation package is too heavily weighted in stock options or restricted stock units, try to renegotiate. Perhaps you can restructure a deal that is more balanced.
- If your employer matches retirement plan contributions in shares of company stock, you may be able to diversify right away. Most companies who match only in employer stock will allow employees to sell the shares immediately, so read your retirement plan documents (commonly called the Summary Plan Description). There's a chance your employer may still require the stock to be held for a few years, in which case you should consider setting up a system so you're automatically reminded to sell the shares and diversify at a later date.
- If you're already receiving stock options or RSUs, you may want to reconsider also participating in an employee stock purchase plan. Again, you may only have so much control over how much of your net worth is tied up in company stock, but buying shares in an ESPP is well within your control.
- If you have stock options or awards that make up a meaningful portion of your overall compensation and net worth, strongly consider working with a financial advisor (and possibly a CPA too) to develop a plan to systematically liquidate and diversify your positions. This doesn't always mean selling everything, either. Instead, it's about developing a strategy that is integrated with your entire financial life to help ensure you're making the most of your stock options, are mindful of the potential tax consequences, and aren't taking on too much risk.
What happens to stock options after an IPO?
If you have stock options in a private company that is planning to go public, your situation may be very different. Pre-IPO companies rely on valuation experts to determine the fair market value of the shares, and depending on the company, there may not yet be a system in place for employees to sell their shares. If your company is planning on going public in the near future, this can be both good and bad news. Good, because you will (eventually) be able to sell your vested and exercised shares in the open market. Bad, because there will be a lock-up period after the IPO that will prevent insiders (e.g. employees) from selling their shares; this can range from 90 to 180 days. What may happen after your company goes public will depend on a number of factors, such as whether you have stock options or restricted stock units at a pre-IPO company.
What happens to stock options if your company is bought by another firm?
Unfortunately, there is really no concrete answer for this question. What can happen will be determined by a number of factors: for example, are your options vested or unvested? Have you exercised the options? Is your company public? Are you being acquired by a private firm? You will probably have to wait until the terms of the M&A agreement are released, but in the interim, read your stock option agreement. There should be some language in there about what may happen in the event of a merger or acquisition. More in this article on what happens to stock options after a company is sold.
What happens to restricted stock units after an acquisition?
Similar to the situation above, what can happen to restricted stock units after a company is bought or merges with another firm will depend on a variety of factors. It isn't always about money either. If the acquiring firm doesn't give its current employees any type of equity compensation, it may not want to disrupt things now. The terms of the deal will play a large role too, so you will want to find out whether your company is being bought in an all cash deal, all stock, or some blend of the two. This podcast on what happens to RSUs after a merger or acquisition has more information.
Managing stock options can be difficult, especially with a busy schedule. When developing a strategy for your equity compensation, make sure it is integrated with the rest of your investment strategy. Financial planning can't happen in a vacuum! If you need help or want to speak with an advisor about your personal situation, please contact us today.
Kristin McFarland, CFP® is a Wealth Advisor at Darrow Wealth Management. She's also a regular contributor to U.S. News and other news outlets.