When it comes to executive compensation, there are various options and factors to consider. Every company is different in terms of what they may offer, but two common forms of equity compensation are stock options and restricted stock units (RSUs). Understanding the differences between these two types, among others, is crucial and important to consider.
In essence, stock options grant employees the right to buy a specified number of company shares at a predetermined price, known as the exercise price or strike price. On the other hand, RSUs offer employees the promise of company stock upon vesting. Unlike stock options, RSUs ensure stock ownership without the need for any upfront purchase.
But what are the advantages and disadvantages of each? What are the main implications in terms of taxes, ownership, and vesting? And, what are some planning strategies to consider?
In this article, we will explore the intricacies of stock options and RSUs. We will discuss the benefits and drawbacks of both compensation types and provide valuable insights. We’ll also cover the basics of vesting schedules and exercising options as well as provide several strategies to consider as part of your overall financial plan. Let’s dive in!
Stock options explained
Imagine having the right to purchase company shares at a fixed price, regardless of their future value. That’s the essence of stock options. Companies grant this right to attract and retain key talent, offering them the potential for significant gains if the company thrives. With options, you have the right to buy a specified number of company shares at a predetermined price, known as the exercise price or strike price. These options usually have a vesting period, which means employees must wait for a certain period of time before they can exercise their options and purchase the shares.
There are two types of stock options: (1) Non-Qualified Stock Options (NQSOs) and (2) Incentive Stock Options (ISOs). Both allow you the opportunity to buy company stock at a discounted price. However, while NQSOs are taxed both at the time of exercise and then potentially again if shares are sold at a gain, ISOs do not incur tax liability upon exercise. You are only taxed once you sell the stock. There is also an AMT adjustment to be aware of with ISOs, but this is an area that you should discuss with your tax professional more thoroughly.
Given that NQSOs are the most common type of options for most employees, we will focus on that type throughout the remainder of this article.
Pros and cons of stock options
- Upside potential: If the share price climbs beyond the fixed price (strike price), exercising your options can yield substantial profits.
- Long-term alignment: Owning options incentivizes you to think like an owner, aligned with the company’s long-term success and shareholder value.
- Retention tool: Companies use options to attract and retain top talent, creating a mutually beneficial partnership.
- Expiration risk: Options have a lifespan, typically 7-10 years. If the share price doesn’t reach the strike price by then, then the option becomes worthless.
- Tax implications: Exercising options triggers ordinary income tax on the difference between the strike/exercise price and the fair market value on that date. After that, any subsequent sale of the shares after exercising the option is subject to short-term or long-term capital gains tax based on the holding period from the exercise date. So, your windfall comes with a tax bill.
- Risk for the risk-averse: Options involve inherent risk tied to market fluctuations. They work best for those comfortable with long-term commitment and market dynamics.
Restricted Stock Units (RSUs) explained
Restricted Stock Units (RSUs) offer employees the promise of company stock upon vesting. Unlike stock options, RSUs offer a more direct path to company ownership without the need for any upfront purchase.
They are essentially virtual shares granted over time, typically vesting over a few years. Once vested, these shares become yours to keep or sell, just like any other stock you own.
RSUs cannot be fully transferable until certain restrictions have been met, which can be performance- or time-related. Think of RSUs as a bonus awarded as stock instead of cash; however, like cash, it is taxed at your ordinary income rate once received (i.e., vests).
Pros and cons of RSUs
- No upfront cost: Unlike options, RSUs require no investment on your part. They’re like bonus shares accumulating over time.
- Immediate ownership at vest: Once vested, RSUs become your property, unlike the conditional potential of options.
- Simpler tax implications: You pay taxes on the fair market value of the RSU when it vests. Similar to options, if you sell your stock at a gain in the future after it vests, you would also incur capital gains tax on the appreciation.
- Limited flexibility: RSUs lack the flexibility of options. You can’t access or sell them until they vest, creating somewhat of a “locked-in” period.
- Less upside potential: With options, there is the potential for higher gains if the stock price rises significantly above the exercise price, while RSUs do not usually provide that same level of upside.
- Tax bite: RSUs also come with tax both at the time of vesting (ordinary income tax), and then again if you sell your shares at a gain in the future (capital gains tax). Generally, RSUs may incur a higher overall tax burden than stock options as well.
Vesting schedules and exercising options
Vesting schedules and exercising options are important considerations when it comes to equity compensation.
Vesting schedules determine when you become eligible to receive the shares of stock or exercise their options. These schedules can vary widely, but common vesting periods range from three to five years. Companies may choose to have a cliff vesting schedule, where you become fully vested after a certain period of time, or a graded vesting schedule, where employees become partially vested over time.
For stock options, exercising refers to the process of actually purchasing the shares of stock at the exercise (or strike) price. Once vested, employees have the choice to exercise their options and purchase the shares. This usually requires the employee to pay the exercise price and any applicable taxes.
If you have either type of executive compensation (RSUs or stock options) and are not sure of your vesting schedule, be sure to ask your Human Resources/Benefits representative and/or request a copy of your agreement.
RSUs and stock options present an incredible opportunity, but thoughtful planning to integrate these into your overall financial plan is crucial. Here are a few potential planning considerations around stock options and RSUs:
1. Vesting deferral – In some cases, companies may allow you to defer RSU vesting to future years beyond the original target date. If that is an option, you may be able to defer the vesting (which is taxed at your ordinary income rate) to a year that you expect to have lower taxable income.
2. Sales strategies – For RSUs, once shares vest, you may decide to sell a portion of your shares to cover associated tax liabilities, and then have the company distribute the remaining shares to you. This is known as “sell-to-cover,” and it helps prepare for the associated tax impact while retaining a significant portion of your RSUs. For stock options, beyond simply exercising and holding your shares, you may decide to exercise-and-sell. With an exercise-and-sell (aka cashless exercise), you buy your options and then immediately sell them without using any cash. In this case, the proceeds from the stock sale would cover the purchase price, tax withholding, and any related fees/commissions. Lastly, be mindful of your holding period before selling. Selling quickly may result in little to no capital gains tax if there is minimal price movement, whereas selling at a gain sometime within a year could result in short-term capital gains tax. On the flip side, holding your shares for a year or longer would result in a more favorable long-term capital gains tax rate.
3. Managing potential concentrations – As you accumulate shares from RSUs and/or stock options over time, the company stock may end up becoming a large concentration in your overall investment portfolio. A concentration is when a single security makes up 10% or more of your portfolio, which may cause more volatility and negatively impact your total portfolio value. Why? Let’s say there is a material event that happens at your company, such as earnings significantly underperforming expectations. This may cause the stock to markedly fall in value, which would result in a larger impact on your overall portfolio performance. Therefore, it is important to manage your concentration through potential rebalancing/sales of shares, or even gifts of shares, over time.
4. Charitable contributions – In years of stock option exercises and/or RSU vesting, you will be taxed at your ordinary income rate. One way to help potentially reduce this tax bite is gifting to charity. You can gift shares of your stock, or gifts of cash, which may provide you with an immediate charitable deduction on your tax return. In addition to gifting to charities directly, you can also gift shares or cash to a Donor Advised Fund.
5. Tax loss harvesting – If you decide to sell your stock in the future, you would incur capital gains tax if the stock has appreciated in value. To help offset this potential tax liability, you may consider harvesting losses in your taxable investments (i.e., brokerage, joint, or trust accounts). This process can be done by selling any security in your taxable account(s) at a loss and then immediately reinvesting into a similar security (just not the same security within 30 days before or after the sale – which triggers the Wash Sales Rule). Harvesting enough of these losses may help offset potential capital gains tax that could come from selling your company stock at a gain.
Conclusion: Making informed decisions about equity compensation
While stock options and RSUs are different and have unique pros and cons, both provide an attractive benefit for employees’ long-term investment picture. You should carefully consider the characteristics of both forms so that you can plan accordingly. Both come with their own, unique tax implications. Therefore, it is important to consult with your tax professional on how these may impact you specifically. Overall, the potential upside of owning RSUs and/or options can add another positive resource to support your long-term goals.
Our team at Tenet is well-versed in executive compensation options, including RSUs and stock options. We partner with clients to determine how these benefits fit within their overall financial picture while also helping to strategize around potential tax impacts and concentrations. Executive compensation can be a complex and challenging topic, so feel free to contact our team (or schedule a meeting) if you need guidance or have any questions!
Registered Representative of Sanctuary Securities Inc. and Investment Advisor Representative of Sanctuary Advisors, LLC. Securities offered through Sanctuary Securities, Inc., Member FINRA, SIPC. Advisory services offered through Sanctuary Advisors, LLC., a SEC Registered Investment Advisor. Tenet Wealth Partners is a DBA of Sanctuary Securities, Inc. and Sanctuary Advisors, LLC.
The information provided in this communication was sourced by Tenet Wealth Partners through public information and public channels and is in no way proprietary to Tenet Wealth Partners, nor is the information provided Tenet Wealth Partner’s position, recommendation or investment advice.
This material is provided for informational/educational purposes only. Any hypothetical examples provided within this material are for illustrative purposes only. This material is not intended to constitute legal, tax, investment or financial advice. Investments are subject to risk, including but not limited to market and interest rate fluctuations.