If you work at a fast-growing company, there is a good chance that part of your compensation is in the form of restricted stock or options. More than ever our clients and prospective clients are reaching out with questions on how to balance the risk of having so much of their net worth tied up in a single company, and the impact stock grants and options have on taxes.
Company stock and options are a two-edged sword. On the one hand, they can make you an overnight millionaire. On the other hand, having your financial future tied to a company can be risky. Not only are your investments tied up in the company’s stock, but your income and benefits are also contingent on the company’s financial health. In other words, if the company experiences some challenges, both your investments and income could be compromised.
Restricted Stock
Companies offer restricted stock as an incentive to keep employees. The terms of the restrictions can vary widely, but usually restricted stock grants have a vesting period. For example, such grants may vest in five equal parts over five years. But should you leave the company before full vesting, you lose the amount that has not vested. Some restricted stock is contingent on the company meeting certain financial goals.
As far as taxes are concerned, when it comes to selling restricted stock, you are taxed up to two times. The first tax occurs upon vesting. For restricted stock plans, the entire amount of the vested stock is counted as ordinary income in the year of vesting. The second tax occurs upon selling. If you decide to hold the stock after vesting and sell at a later date at a gain, you are taxed on the difference between the sale price and the value of the stock at the date of vesting.
Stock Options
A stock option gives its holder the right, but not an obligation, to buy common stock at a given price (the “exercise price”) that is typically equal to the stock’s current market price at the time of grant. Assuming the stock price rises, this option will gain value. Stock options can create massive wealth through leverage. For example, let’s say an option has an exercise price of $100 while the stock is selling at $110. The option’s intrinsic value is $10. If the stock price moves to $111.10, the stock’s value has increased by 1%, but the option’s intrinsic value has moved from $10 to $11.10—an 11% gain!
But leverage works the other way too. If the stock price drops below the option’s exercise price, the option is “out of the money,” meaning that for the time being, its intrinsic value has dropped to zero. To make matters worse, if you hold the option to its expiration date and it’s out of the money, it expires worthless.
As far as taxes are concerned, it all depends if your options are incentive stock options (ISOs) or non-qualified stock options (NQSOs).
For ISOs, you do not pay taxes on exercise. Instead, you pay taxes when you sell the stock and if done correctly, you can structure the tax liability so you pay taxes at a favorable long-term capital gains rate. One major consideration when exercising ISOs, however, is the fact that ISOs can push you into the Alternative Minimum Tax (AMT) which could increase your tax liability for the year in which you exercise.
For NQSOs, you pay taxes at ordinary income rates when exercised. And like restricted stock, if you hold the shares after exercise and sell at a gain at a late date, you are taxed at capital gains rates.
Putting It All Together
Restricted Stock
When building long-term wealth, it is usually best to sell restricted stock as soon as it vests and reinvest the proceeds in a diversified portfolio built for long-term growth.
Generally, the order of selling should be: 1. Stock held at a loss 2. Stock held in tax-deferred accounts 3. Stock held at a gain, but in order of the smallest gain first.
Options
For options, pay attention to the market price of the option. The price of an option in the open market is a combination of the “intrinsic value” (the difference between the stock price and the exercise price) and the “time value” (the value the market assigns to the right but not the obligation to buy the stock) and it is advisable to exercise when time value reaches 30% of total value. For example, if the price of an option is $10 and the intrinsic value is $7, the time value is $3 and it makes sense to exercise.
The time of year matters as well. For example, if you are close to the end of the calendar year, waiting until January may delay your tax liability for another 16 months.
Please note that every situation is different so you should always speak with your financial professional before taking any action.
While restricted stock and options are a valuable part of compensation plans, we recognize that they can be confusing to navigate, and this post serves as a broad guide.
If you have questions on how to think through your specific situation, please feel free to set up a free introductory call.