Key takeaways

  • Many companies offer shares of their stock as an incentive and reward to employees.
  • There are two ways to think about equity compensation: as a bonus or as an investment.
  • There are two major types of equity compensation: shares you’re given and shares you have the option to purchase.
  • There are laws governing equity compensation plans, but every company’s plan is different.
  • There are many terms you need to understand before exercising your stock options. 
  • Taxes vary widely for different forms of equity compensation

These days more and more companies offer equity compensation to their employees as one of the benefits. Of course, there are insurance benefits and retirement plans as well. Even some private companies who don’t have stock available to the public do it. What does that mean? It means that your employer may give you shares of company stock, or it may give you the option to purchase shares at a certain price.

Behind those simple statements is a complex web of financial decisions and tax laws that can vary widely, depending on the type of equity compensation, your financial situation, and your financial plan. If your employer offers equity compensation, here’s how to make sure you take full advantage of it and don’t leave money on the table.

Why employers offer equity compensation

Employers typically offer equity compensation as an incentive, a reward, or both.

Sometimes shares of stock, or the option to purchase shares of stock, are awarded for meeting certain performance targets. More often, shares are part of a larger compensation package designed to attract and retain high-quality new hires.

Two ways to think about equity compensation

Although there are several different types of equity compensation, your decisions about how to manage yours begins with one fundamental question:

Do you want to treat your equity compensation as a bonus, similar to a cash bonus, or do you want to think of it as an investment? 

If you see it as a bonus, then you may want to sell the stock soon after you acquire it.

In that case, you want to calculate the best way to make the most of your money, taking into account the taxes you’ll owe. The taxes can vary widely depending upon how long you hold your stock; a tax pro or a CFP® professional from Facet Wealth can help.

If your equity compensation is an investment for you, then be mindful of how much of your financial future is tied up in your company’s stock. Although that decision will vary for everyone, many planners recommend that no more than 5-10% of your entire portfolio is concentrated in the stock of a single company.

Two types of equity compensation

Although there are several types of equity compensation, they all work in one of two ways:

The first type is simple. You’re given shares of company stock at no cost on a certain date. This would be very similar to a cash bonus, except instead of getting $5,000 in cash you’re receiving $5,000 worth of company stock. Normally this will be spelled out in a stock agreement which is separate from your contract or employment agreement. 

The second type is when you’re given the option to buy a certain number of shares of your company’s stock at a specific price on a certain date. You don’t own the shares until you buy them. Your company might tell you that you can buy up to 500 shares of your company’s stock at a price of $25 as of June 1. If the stock is worth more than $25, you’re essentially given the opportunity to buy shares at a discount. 

Because this is an option, you can buy fewer shares or none at all. Typically, you have 10 years to exercise that option, unless you leave the company, but check with your employer.  You can usually wait until the value of the shares is above your purchase price.

Understanding the terms

If your company offers equity compensation, you’ll see certain terms in your stock agreement. The most common are below. Not sure about your particular stock agreement? A CERTIFIED FINANCIAL PLANNER™ professional at Facet Wealth or a tax expert can help walk you through all of the information. 

For all types of equity compensation, you should know:

Equity: This is your stock. When you own stock in a company, you have equity in that company; you’re a partial owner.

Grant: The number of shares you’re given, or the number of shares you may purchase, on a certain date. Exercising your grant means you’re buying the shares.

Vesting (vesting period): Date on which shares become yours.

Cliff: When your shares first begin to vest. Shares may vest over a period of years. Going “over the cliff” means your shares have begun to vest.

For situations where you’re given the right to purchase shares, rather than the shares themselves, you’ll see these terms:

Exercising: The act of buying shares. When you exercise your grant you’re buying shares.

Expiration: When your grants expire.

Strike Price: The price at which you may buy shares at some future date.

Spread: The difference between the price you pay for a share (strike price) and what that share is worth.

Underwater: When the strike price is more than the shares are worth.

For example, your equity compensation plan might say you received a grant with the right to buy 4,000 shares at $10/share, with a one-year cliff and vesting over four years. That means after your first year of employment you have the right (but not the application) to buy up to 1,000 shares at $10 each. Typically each month you’ll have the opportunity to buy more shares. You can buy your shares right away or wait for 10 years, unless you leave the company.

Three major types of equity compensation

Restricted Stock Units (RSUs): The simplest form of equity compensation. Shares are granted to the employee but access to them is “restricted” for a period of time. Typically, you must remain with the company for some number of years to get all of your shares. Shares will usually vest when the restriction goes away, over a period of time. Shares are taxed as ordinary income, as if you’d received a cash bonus rather than shares. Taxes are due when you receive the shares, not on April 15 when you file your tax return.

Non-Qualified Stock Options or Non-Statutory Stock Options (NSO): An NSO is the right, but not the obligation, to purchase shares of the company at a pre-set price, the strike price. Employees typically have 10 years to exercise their options as long as they stay with the company. If they leave, they usually have 90 days to exercise their options and purchase shares. If the options aren’t exercised within 10 years, they expire and have no value. Taxes are due on the spread, or the difference between what the employee paid and what the shares are worth. The spread is taxed as ordinary income. As with RSUs, taxes are due when the options are exercised.

Incentive Stock Options (ISO): As with NSOs, employees are given the right to purchase shares of company stock at a set price. However, there are two important tax differences. First, taxes are not due when grants are exercised, which means employees don’t immediately have to sell shares to pay taxes. Second, if employees hold shares for at least one year after the exercise date and two years after the grant date, shares are taxed as long-term capital gains, not ordinary income. There are limits: only the first $100,000 in income from ISOs receives this preferential tax treatment, and high-income employees may be subject to the Alternative Minimum Tax, or AMT.

Being smart about equity compensation

Understanding stock compensation is no small feat, and it can have a big impact on your taxes and your overall plan. Please take a look at the video, “Equity Compensation Lunch & Learn” for additional information.

To learn how a financial plan that integrates all facets of your finances, including RSUs and options, can help you minimize taxes and maximize your value, schedule a free, introductory call with a CFP® Professional at Facet Wealth today.