If your employer has decided to offer you equity compensation, you are already in a great position. This benefit, offered as company stock shares, is typically given to highly regarded team members that the company wishes to retain. While equity compensation can significantly enhance your savings and help you reach your financial goals, it demands careful handling. Various forms of equity compensation exist, each with distinct terms and unique tax implications. So, if you’re the recipient of (or are about to receive) such compensation, it’s crucial to understand the specific terms and conditions of your package.
Equity compensation packages don’t come with a user manual. Most companies do not have in-house experts to offer personalized financial advice or instruct you on managing your grant. They can explain the procedure and functionality, but they cannot provide tailored financial planning recommendations. With an increasing number of firms offering equity compensation to their employees, understanding the unique aspects of these compensation forms is a must for recipients. In this article, we will take a look at two common compensation models: incentive stock options (ISO) and restricted stock units (RSU).
ISO vs RSU: Breaking Down the Terms
Before we get into the specifics of ISO vs RSU, it is important to understand some commonly used terms related to these plans:
- Grant Date – The date the company’s board of directors officially approves the award.
- Grant Price – The stock’s fair market value on the grant date.
- Vesting – The process of earning shares over a period of employment.
- Vesting Period – The duration during which shares become vested, as outlined in the option grant agreement.
- Vesting Value – The fair market value of shares that become vested on the vesting date.
- Exercise – The act of informing the company of your intention to use your option to buy stock.
- Exercise Price or Strike Price – The cost you pay for the underlying shares of stock when exercising an option. For instance, if you have the option to buy 500 shares at $10 per share, the $10 is the exercise price.
- Spread – The difference between the stock’s current value and the exercise price.
What is an ISO (Incentive Stock Option)?
Incentive stock options (ISO) are one of the two types of employee stock options (the other being non-qualified stock options or NQSO). An ISO allows an employee to buy stock in the company later on, at the price of the stock when the ISO was offered. ISOs are popular with smaller companies on the verge of large growth. When an employee exercises an ISO, they do not immediately incur regular income tax liability. However, they may have to pay alternative minimum tax (AMT).
In terms of retirement, there are a couple of things to consider with ISOs:
- Timing of Sale: If you hold the stock for at least one year after the date of exercise and two years after the date of grant, any profit made from selling the stock is considered long-term capital gains and taxed at a lower rate than regular income.
- Retirement Portfolio Diversification: Stock options, including ISOs, can be a great tool for growing wealth, but they also introduce a significant amount of risk into a retirement portfolio because they are tied to the performance of one company. It’s important to consider how this fits into your broader retirement strategy and asset allocation.
- Retirement Account Contributions: The exercise of an ISO itself does not provide income that can be used to make a contribution to a retirement account, such as an IRA or 401(k). Only W-2 income or self-employment income is eligible for these contributions.
- Rollover of ISOs at Retirement: Generally, ISOs cannot be rolled over into a retirement account like an IRA or 401(k). The options must be exercised while you’re still employed by the company or within a certain time period (usually 90 days) after leaving the company.
Remember to consult with a financial planner when dealing with ISOs, as they are complex and have significant tax implications.
Pros and Cons of ISOs
ISOs come built in with the risk that if the company’s stock price fails to increase before the option expires, the ISO is worthless. When it comes to the stock market, there are no guarantees. On the other hand, if the company’s stock price does increase over time and the employee is willing to take that risk, there is the potential for significant gains.
What is an RSU (Restricted Stock Unit)?
The most straightforward equity compensation offering, a restricted stock unit (RSU) is a right to receive stock after you have satisfied certain conditions imposed by your employer. RSUs are popular at companies that are larger and more established. Conditions of receiving the stock can include:
- Staying with the company for a certain amount of time.
- Reaching a certain sales goal.
- Your team completing a project before a deadline.
If these requirements are not met, you will not receive anything. Remember, in the case of restricted stock units, the shares are not yours until they’ve been earned – which happens when the vesting period is met. This implies that you won’t receive dividends that the company might pay out before you meet the conditions. However, some companies may offer an equivalent for dividends to those who have been granted RSUs.
Fortunately, in most scenarios, an employee does not incur a tax liability when they receive a restricted stock grant. However, once the employee has fulfilled the vesting conditions and obtains the shares, they must report the value of these vested shares as compensation income. This amount will be recorded as wages and will be included on their W-2. Consequently, this value is subject to federal, state, Social Security, and Medicare tax withholdings.
Pros and Cons of RSUs
When compared to ISOs, RSUs are less risky and not dependant on the stock price at any given time. They offer a more predictable revenue stream and guarantee at least some money as long as the company’s stock has value by the vesting date. However, as mentioned before, RSUs disappear if the vesting conditions are not met.
ISO vs RSU: Which is Better for Retirement?
ISOs and RSUs, as with all forms of equity compensation, come with a variety of risks and benefits. One is not inherently better than the other, but it is important to understand the pros and cons of each. There are a lot of questions to ask yourself when deciding what to do with these packages, or whether to choose ISO vs RSU. How do stock options influence your long-term goals and objectives? How does the equity align with your risk tolerance and other investments? What does your tax situation look like? Should you exercise the option and retain the shares? Or should you consider a cashless transaction?
As equity compensation becomes increasingly popular, it’s critical for employees to understand not only the type of equity they’re receiving but also its tax implications. Furthermore, it’s important to integrate the stock options you receive into your overarching financial strategy. If you’re fortunate enough to be receiving equity compensation from your company, I would highly recommend contacting your financial planner. This will enable you to gain a full understanding of how equity compensation affects your financial circumstances.
For answers to more common retirement questions, read our Comprehensive Guide to Retirement Planning in New Jersey.