How Do They Work and How Can I Use This Tool For Retirement Savings?
Company stock compensation plans are a big deal and are often offered to employees at some of the most iconic employers that have ever existed. If you are eligible for employee stock compensation congratulations. But there is a lot to learn about these different plans. Regardless of the exact type of plan that you are eligible for, you will want to learn about the basic workings of the plan, the rules and regulations, how your tax burden will change, and how you can use these tools to plan for your retirement.
This article offers several over-simplified examples of different compensation plans. Therefore, the smartest thing you can do is to have an individualized meeting with a financial professional to discuss your full range of options so that you can have the best financial future possible. Educate yourself using reliable resources such as professional financial planners and tax experts. What your co-workers say at work may or may not be true as several misconceptions have arisen surrounding stock compensation plans.
Employee Stock Options
Employee Stock Options (ESO) are a form of company compensation where the employee is given the option of when to sell stocks. “Exercising” your stock option occurs if and when you buy the stocks that are offered to you. If done right, ESOs can offer opportunities for large financial gains.
Important things to know about ESOs:
- ESOs allow employees to share in the growth and success of a company but without personal financial risk to the employee (until the stock option is exercised)
- The stock value is hypothetical until the option is exercised
- They serve as both a reward and as a motivator – Hard work will benefit the company and company growth will raise the value of company stock which will benefit the employee financially
- The type of stock option determines its tax treatment
As an employee with an ESO, you will want to know the basics about the stock options available to you, when your stock options will be vested, how and when your options will be taxed, as well as some of the strategies and risks with regards to exercising your stock options.
How ESOs work:
Your employer will offer you the chance to buy company stock at a specified time, depending on the employer’s vesting plan. But, realize that the stock option won’t be available indefinitely since there is an expiration date included in the plan.
There are 2 types of ESOs
- Non-Qualified Stock Options (NQSO)
- Incentive Stock Options (ISO)
How do vesting schedules work?
ESOs are subject to a vesting schedule. When you begin working with a company, you most likely will have to wait a period of time in order to have all or a percentage of your stock options become available to you (i.e. vested). A vesting schedule is another method that employers use to retain employees; the longer the employee stays with the company, the greater the financial gain. Once a compensation form is vested, the employee has a legal right to claim that compensation.
A graded vesting schedule may occur as follows (companies use varying schedules):
|
Time Employed |
Percent of ESO Vested |
|
1 Month |
2% |
|
2 Months |
4% |
|
3 Months… |
6%… |
|
…23 Months |
98% |
|
24 Months |
100% |
A cliff vesting schedule is, well, like going off a cliff. It’s a sudden change in the percent vested.
|
Time Employed |
Percent Vested |
|
1 Year |
0% |
|
2 Years |
100% |
Companies may also decide to blend the vesting schedule. For example, a company may use a graded scale, but with a 1-year cliff to start. If the employee were to leave the company prior to completing the first year, he or she would not have the right to any part of the stock. Vesting schedules vary so check with your employer to learn about your schedule. It is important to know when your compensation will be vested so that you can make correct decisions.
To compare, companies that offer 401(k) accounts with employer matches, for example, also typically use a vesting schedule. The employer match might become gradually vested at 20% per year, or they may use a cliff schedule of 100% vested status after three years of employment. If the employee changes jobs prior to the time at which the employer match is vested, he or she has no right to that match money. But, once vested, that matched money belongs to the employee.
Once the predetermined amount of stock is vested, you will be offered stock at the grant price. If you decide to exercise your options, you must do so prior to the expiration date.
Example:
Let’s say that your employer offers you the right to purchase 1,000 shares of company stock at $10.00 per share (the grant/strike price) once vested. Let’s imagine that your company’s stock is valued at $20 on the grant date. Alternatively, you could be granted a percentage of stock, let’s say 25%, per year over 4 years, at which point you would be fully vested.
Your option would look like this:
The fixed grant price is $10.00/share in the grant year of 2020.
Market price at grant date: $10.00/share
Expiration date: 2030
Exercise date: June 1, 2025.
Market price on exercise date: $30.00/share
If you decide to exercise your stock options, which you can perform on June 1, 2025, you will buy the 1,000 shares for a total of $10,000. If you don’t exercise your options prior to year 2030, you will lose your stock options. Imagine that the market price on the grant date was $15.00 (or $25, or 50, etc.), and the company has been seeing increasing stock prices for several years. These factors may influence you on when exactly you decide to exercise your options.
The question for many then becomes:
When should I exercise my stock options?
The best answer is to speak with your fiduciary financial planner and tax expert. However, the decision to exercise should be based on a combination of:
- Tax rates
- Consider ordinary income tax, alternative minimum tax, and long-term capital gains tax
- Type of stock option (ISO vs. NQSO)
- Years until retirement
- Stock prices
- Are your stocks “underwater/out-of-the-money” or “in-the-money?”
- Under-the-water represents devalued stocks whereas in-the-money represents stocks that have increased in value
What’s the benefit of ESOs?
ESO compensation allows you to purchase stock at a price that theoretically should be below the market value of a share. ESOs are therefore more valuable than buying exchange-traded funds, which are priced above the grant price of ESOs. ESOs give you more flexibility and bang for your buck. However, if you allocate too much of your portfolio to your company’s stocks, you risk being highly vulnerable if those stocks decrease in value.
Taxation of ESOs
- Nonqualified Stock Options:
As the name implies, non-qualified stock options are not eligible for any form of special tax treatment.
When you exercise a NQSO, the spread (the difference between the grant price and the market price of a stock) is considered earned income and you will, therefore, be subject to:
- Payroll taxes
- Social Security and Medicare Tax
- Ordinary taxes
- At your particular tax bracket rate
- Capital gains tax on any appreciation of stock, or take a capital loss in the case of decreased stock value
- Incentive Stock Options:
The ISO is taxed differently than nonqualified stock options. With ISOs, you will not be subject to payroll taxes, and other taxes will depend on exactly how you exercise your options. If you exercise your stock option but also sell your stock in the same calendar year, you will pay your ordinary tax rate on the spread of the stock.
If you exercise your options but hold the stock for one year past the exercise date, the spread amount will be used for Alternative Minimum Tax (AMT) calculation, which you may have to pay. However, by holding the stock for one year after exercising your option, you can avoid paying ordinary tax and instead pay a long-term gains tax, which is lower than the ordinary tax, especially for high-income earners.
However, don’t let any one particular tax rule, or the fear of paying certain taxes, be the ultimate decision-maker for deciding what to do with your options. Having too large of a percentage of your portfolio allocated to just one company can also be risky. Consider what would happen to your portfolio if your company stock falls dramatically, even below the grant price. Again, it is wise to speak to tax and financial professionals before making any decisions.
How can I use ESOs for retirement planning?
Use the profit to:
- Diversify your existing portfolio
- Pay down debt
- Build up an emergency fund
- Use the earnings to build a strategy that allows you to max out retirement accounts
- Note that you can only fund a Roth and a Traditional IRA with cash and you can only use salary deferrals to fund employer-sponsored retirement plans, like a 401(k)
- You can’t exchange options into retirement accounts
- Convert a Traditional IRA to a Roth IRA using the stock profit to pay the applicable taxes. This may make sense depending on the tax bracket you think you will belong to in retirement and/or depending on your eligibility (income limits apply) to contribute to a Roth IRA
Restricted Stock Units- RSUs
RSUs are another form of compensation that companies use to recruit and retain solid employees. RSUs may be distributed to employees based on a vesting schedule or when certain milestones or achievements are met. The following are key elements to RSUs:
- Once vested RSUs are assigned a fair market value
- Are tax-deferred, until vested
- Dividends, if offered, appear on a yearly W-2 form
- Are less risky than stock options (ESOs are subject to more volatility)
- Don’t confer voters’ rights until vested (no rights at all if cash given in lieu of stocks)
Typically, RSUs may be distributed as follows:
The employee is offered 1,000 RSUs that are vested at 25% (250 RSUs) each year and the grant price is $10 per unit. Let’s imagine that the market value of the stock increases $5 each year.
Year 1: 250 at $10 = $2,500
Year 2: 250 at $15 = $3,750
Year 3: 250 at $20 = $5,000
Year 4: 250 at $25 = $6,250
At the end of the 4 years, the employee has a total of $17,500 in RSUs. Notice that there is no strike price (grant price) with RSUs like there is with stock options. Consider what would happen in the case that your company’s stock, which was granted to you at a grant price of $10.00/share, fell to a value of $5.00/share? In this case, you could not sell for a profit, you are under-the-water.
What if the same situation occurs with RSUs and the value of your company’s stock falls? Well, since there is no strike price, you are not buying the stock at any predetermined value, so even if market value falls, with RSUs you are still going to get some benefit, known as “downside protection.”
Of course, companies will not grant as many shares via RSUs as they would in stock options. Bill Gates recognized that stock options were akin to playing the lottery because if you win, you win big. Imagine how big you could win if a company’s stock increase by 50%? However, stock options can be very volatile and employees may not win at all. RSUs stabilize the playing field and is why they were introduced to Microsoft employees.
Taxation of RSUs
RSUs are taxed once they are vested and distributed to the employee and taxed at the market value at the time they are vested. That is different than how stock options are taxed. To be clear, RSUs are taxed once vested, unlike stock options that are taxed once exercised.
RSUs are subject to:
- Federal income tax
- Payroll taxes (Social Security- up to yearly maximum benefit base, & Medicare)
- Applicable state and local taxes
- Capital gains tax with stock appreciation
- Section 83(b) is only for restricted stock, not RSUs
A fairly common practice among companies is to reach a “net-settlement” and essentially ‘pay’ the applicable payroll tax amount:
- RSUs are distributed to the employee
- The amount in taxes is calculated, and the corresponding value in RSUs is withheld and returned to the issuing company
- Withheld value is used to cover payroll taxes
Of course, like with ESOs, employees want to know if they should hold or sell their RSUs and common misperceptions surround this issue. Many media outlets have reported on RSU recipients that decide to hold RSUs because of a perceived tax benefit of paying long-term tax rates instead of the more pricey short-term capital gains tax. Additionally, people often fall into the trap of endearment, thinking that their company will always do well and by holding onto company stocks, the shareholders will, with patience, get very rich. History is littered with companies that once were giants but eventually fell.
For most people, the correct decision would be to sell the RSUs and use the cash to reinvest in a more diversified portfolio. Remember, having too much money allocated to any one company can reduce diversification, and increase ‘concentration risk.’ In other words, by holding the RSUs you are unnecessarily increasing your risk. Also, consider the possibility of your shares decreasing in value. If this happens, you will have paid taxes on the larger original value (at the time of vesting) plus now you have lost value on the shares, a double-whammy.
However, the year that your RSUs vest, your taxable income is going to bubble. Take advantage of the help of a tax professional and financial planner and perform a big-picture evaluation of your particular financial situation. There may be benefits in terms of capital gains and additional Medicare tax rates by holding onto the RSUs.
How can I use RSUs to plan for retirement?
- Use RSUs to beef up an emergency fund
- Use the cash to max out retirement accounts, as applicable and decrease the concentration of investments aiming to diversify
- Sell most RSUs, but hold on to some. If the stock increases in value, sell some more. If the stock is devalued, you won’t take as big of a hit.
Employee Stock Purchase Plans (ESPP)
ESPPs are a compensation plan that employers use to offer eligible employees the opportunity to buy company stock at a reduced rate. Once eligible, the employee will begin to make contributions, usually as payroll deductions, toward the plan. After a predetermined period of time, the company will use the accumulated contributions to buy the employee company stock at a reduced rate.
There are two types of ESPP
- Qualified ESPP
- Non-qualified ESPP
The basic workings of both types of ESPPs are very similar. Major differences include favorable tax treatment for qualified ESPPs whereas non-qualified plans don’t enjoy the same tax advantages. Qualified plans are more common, and that’s what we will focus on here.
Key ESPP elements include:
- Yearly contribution limit of $25,000 (thus, purchased stock is limited to $25,000 worth of shares)
- This is a fixed amount that won’t change for the year, even if stock prices fluctuate
- Actual shares purchased may be below this limit
- Contributions are after-tax
- No taxes on stocks until they are sold
- 15% maximum discount on stocks
- Employees that own more than 5% of employee stock can’t participate
- Stock is purchased during offering periods
- Funds used to purchase stocks are immediately vested
- Discounted stock
- Built-in discount
- ‘Look-back’ provision
The ‘look-back’ provision allows the ESPP to provide the employee with the lowest of:
- The closing stock price on the date of the purchase
- The closing stock price on the original offering date
The plan may offer both the ‘look-back’ benefit plus a discount on that ‘look-back’ price, offering a tremendously discounted stock price. However, factors that cause the stock price to decrease can also devalue the ESPP and effectively limit the amount of stock purchased, even to an amount below the allowed $25,000 so it can go both ways.
Taxation of ESPPs
With ESPPs, there are two ways to sell the stock, each having an effect on tax treatment:
- A qualified disposition (more favorable tax treatment)
- A non-qualified disposition
What makes a sale a qualifying disposition?
The stock must have been held for at least 2 years since the offering date, and 1 year since the purchase date.
If these qualifications are not met, the sale is categorized as non-qualifying.
Qualified Disposition Taxation
Under a qualified disposition, the discount on the stock purchase is taxed as ordinary income and the gain will be taxed with long-term gain rates.
In a non-qualified disposition, both the discount and capital gain on the stock will be taxed at the ordinary tax rate, increasing the amount of taxes paid.
If you purchased a $500 stock at a 15% discount for a total of $425, and the difference in the price from the purchase date (including the discount) and the price on the sale date is $200, then you would:
- With a non-qualified disposition, pay an ordinary tax (at 33% of $200) of $66
- With a qualified disposition, pay an ordinary tax on the discount of $75 (33% of $75) = $24.75 and a long-term gain tax at 15% of $200, which = $30.
- $30 + $24.75 =$54.75
You can see that if an employee owned more stock, more like thousands of dollars of stock, the differences in taxes would also be greatly magnified. As a word of caution though, don’t let this fact influence you too much when deciding to sell or hold your stocks.
Employers usually report ESPP purchases and gains on a W2 form. If yours does not do this, you must file Form 1040.
By this point, you are probably wondering if you should hold onto or sell your ESPP stock?
Like with the other stock compensation options, it’s always going to depend. You have to evaluate your individual financial circumstances with the help of a financial planner.
It bears repeating that holding too much stock in one company, especially your company and the company that pays your wages, decreases diversification and exposes you to more risk. If something economically goes wrong at your company and the stocks plummet while the company decides to lay you off, you could really suffer. It’s impossible to know what is going to happen to the value of any one company’s stocks over time. You may have lots of confidence in your employer, or you may have none. This is also going to affect your decision.
By having received shares at a discounted price, you are already getting that 15% discount. In other words, that’s a positive return on investment. Holding onto the shares in order to satisfy qualified disposition criteria may work out, and it may not. Again, talk to professionals. Don’t let taxes be the sole reason to sell or to hold. However, in this case, selling is probably a safe move.
How Can ESPPs Help Me Plan For Retirement?
- Sell shares and further diversify your portfolio
- Contributions are after-tax, don’t spread yourself too thin
Wealth management is our passion! Let us help you make the best decisions today so that you have the best future possible. Contact us now to schedule a time to discuss your financial questions.
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