As pensions are slowly vanishing, defined-contribution plans and equity awards are now a significant part of many company’s compensation packages, particularly with tech companies that want to attract and retain workers in an increasingly competitive landscape. With proper planning, equity awards can help build great long-term wealth. However, many employees don’t fully understand what these options are, how they work, and the tax ramifications of their actions — which have the potential to cause costly mistakes.
Basic terms you need to know
- Grant Date: The date the options are granted to you.
- Vesting Schedule: The timing and how many shares can be exercised.
- Expiration Date: The option doesn’t last forever. Most stock options expire in 10 years.
- Exercise Price: A specified price an option can be purchased. The gain between the exercise price and the current market value is taxed at ordinary income tax rates.
Here are three common types of equity awards and how they work
1. Stock Option Plans
Stock options give employees a right to purchase a specified number of shares of a company’s stock at a fixed price. The option typically expires 10 years from the grant date. Employees receive either one of two options: Incentive Stock Options (ISOs) or Non-Qualified Stock Options (NSOs). The main difference between the two plans is the tax treatment. ISOs are only offered to employees and are eligible for favorable tax treatment if executed by the rules. NSOs can be offered to employees and non-employees and are taxed as ordinary income.
2. Employee Stock Purchase Plans (ESPPs)
ESPPs give employees an option to purchase shares of their company’s stock at a price discounted at a rate stated under the ESPP up to 15 percent via scheduled/payroll deductions. Only publicly traded companies may offer this plan. The IRS allows a maximum contribution of 15 percent or $25,000/year. Most ESPPs have a lookback provision that applies the discount from either the offer date price or purchase date price, whichever is lower, to prevent the stocks from losing their value.
Example: ESPP with a 15 percent discount with a six-month purchase period and lookback.
|January 2020||June 2020|
|Offer Date||Purchase Date|
|Price of stock is $20 per share||Price of stock is $25 per share|
|With six-month lookback, the purchase price is $17 (15 percent discount from $20)|
The above example shows a gain of 47 percent ($8 spread divided by $17 purchase price). Most ESPPs qualify for favorable tax treatment based on the price of the stock on the offer date, compared to the price of the stock on the date of purchase, assuming a 15% discount rate.
3. Restricted Stock Units (RSUs)
To attract the best talent, companies offer RSUs as a form of compensation in addition to base salaries and other benefits. After certain conditions are met, usually after being with the company for several years or based on performance goals, a specified number of shares are awarded to employees. Once the shares are vested, they can either sell them or keep them. If sold immediately, the cash can be used to satisfy other financial obligations, or better yet, invest in a diversified portfolio. Conversely, keeping the stocks may trigger a capital gains tax.
Sample Vesting Schedule: assuming 5,000 shares granted, with a four-year vesting period, 25 percent vests each year.
It’s important to read the plan agreements carefully and understand the IRS rules to make an informed decision. Visit the Fidelity Stock Plan Resource Center to learn more about the different types of equity awards. If you need further guidance on how to best execute your equity compensation, we are here to help.
Important Disclosure Information:
Different types of investments involve varying degrees of risk, including the risk of loss of your entire investment. Past performance is not indicative of future results. CPWM and its employees can give no assurance that the performance of any specific investment recommendation or investment strategy discussed herein, whether directly or indirectly, will be profitable, or that it will be equal to any historical performance level discussed herein. The discussion or information contained herein is not intended to be, and should not be deemed as, personalized investment advice. The recommendations made may not be suitable for your specific individual situation and we encourage you to discuss with your financial professional before undertaking any investment strategy or recommendation contained herein. The discussions contained in this blog is current only as of the date hereof and may change due to a number of factors, including varying market conditions.