Many companies and tech startups leverage compensation plans to make their upper-level management positions more appealing. Comp plans often include a base salary, as well as employee stock options and additional benefits to round out executive offers.
For employees, the prospect of getting a stock option offer as part of their compensation package can be a milestone moment. They look forward to achieving this level in their careers for obvious financial reasons, but it also brings a sense of accomplishment and prestige.
Unfortunately, because so many employees spend so much of their career looking forward to receiving stock options – they don’t think about the one primary drawback: taxes. Luckily, with a little bit of planning, stock options can continue to be a financial boon for employees.
Understand Your Options
The first step employees need to take is getting a grasp on what type of stock options they are being offered. When you understand what’s being made available to you, you can better plan for taxable events, and find a way to offset costs.
In general, there are a few different types of stock options available:
- Restricted Stock Units (RSU)
- Non-qualified Stock Options (NQSO)
- Incentive Stock Options (ISO)
- Employee Stock Purchase Plans (ESPPs)
We’ve written blog posts outlining the basics of what you need to know about each type of option commonly offered to employees (linked above). However, the foundation for understanding your stock options is the same regardless of what you’re offered. It’s important to know:
- How much stock you’re being granted
- Whether you have to purchase the stock (like you would through an ESPP)
- What your vesting schedule is (or when the stock becomes available for you to use)
- How your unique stock option is taxed
Be Aware of Taxable Events
Each stock type is subject to different taxable events and rates. For example, for RSUs, the stock units are taxed when they vest as ordinary income. Then, if you continue to hold onto them in hopes that the stock price goes up, they could be subject to short or long term capital gains tax depending on when you sell.
Other stock options, such as NSOs and ISOs, have more complex tax implications. Employees need to pay close attention to the type of stock option they have, how exercising impacts their options, and whether or not the sale of their stock will trigger either capital gains taxes or Alternative Minimum Tax (AMT).
Make a Plan to Offset Costs
Of course, the primary goal you should have when it comes to managing your employee stock options is to work with a tax professional and your financial planning team to come up with a plan to offset costs. However, if you’re looking for a few financial steps you can take to minimize your tax liability, consider the following:
- Exercising your options early, and selling. If your options are subject to ordinary income tax upon vesting, it may be in your best interest to sell the same day they vest.
- Exercising your options early, and holding. Another option is to exercise your stock options, then proceed to hold your options until you can successfully avoid short term capital gains taxes and pay more favorable long term capital gains taxes, instead.
- Avoiding the AMT. Some stock options, like ISOs, are subject to the Alternative Minimum Tax (AMT). You can plan ahead by understanding how the AMT works, and creating a strategy that ensures you only exercise the amount of stock that keeps you under the gross income limit can help. You can also work to beef up any activity that would lower your gross income, like maxing out contributions to a workplace 401(k) or Traditional IRA.
- Considering claiming an AMT credit. If you have ISOs and are hit with the AMT, you may be eligible to claim an AMT credit in future filing years that reduces your regular taxes.
- Ensuring you withhold the appropriate amount for taxes. No matter which way you look at your stock options, some form of taxes will be owed – ordinary income tax, capital gains tax, or the AMT. It’s important to make sure that the proceeds from exercising your options (or other funds in your financial plan) are available to cover your tax bill.
What if you Change Jobs or Retire?
In addition to the points mentioned above, there are some specific things to consider if you have unexercised stock options and plan to leave the company due to a job change or retirement.
First, you need to know whether your options are vested or unvested. If you have unvested options when you leave the company, you most often will simply lose them. Your company may provide for continued or accelerated vesting if you are leaving because of retirement. Check with HR or your benefit documents to find out.
You’ll also need to plan for what to do with your vested options. Your company will decide how much time to give you, but typically you’ll have up to 90 days to exercise them before you lose them, too. If you have ISOs, you’ll have to exercise them before 90 days is up regardless of how long the company gives you or they lose their favorable ISO tax status. Instead, they become NSOs. The main effect here would be that the difference between your exercise price and the market price of the stock, known as the “bargain element”, would be taxed as ordinary income. That could result in a significant increase in your tax bill.
Be Forward-Thinking, Speak With Your Advisor
Even if your stock options look simple on the surface, it’s important to work with your financial team to create a forward-thinking plan.
Reach out to your financial planning team if you know you have stock options coming your way, or if you’re sitting on options that are about to vest. Having a plan in place can help to ensure you minimize your tax liability while leveraging your options.