When you get a job offer, your benefits package may include more than just your salary, healthcare, and vacation time. In addition to all that—and maybe some work-from-home allowances—you may also be offered an employee stock plan.
Two of the most common offers, employee stock options (ESOs) and restricted stock units (RSUs), both give you the chance to eventually become a shareholder in your company.
Sometimes, an employee stock plan is offered to everyone as a companywide benefit. Other times, it’s a custom plan that’s baked into an executive job offer as either a recruitment and retention incentive, a way to cover the lack of cash flow in a startup, or both.
And sometimes, you get a choice between ESOs and RSUs. Having the option to own stock in your employer could provide some big financial benefits—especially if you believe in the company and its future.
But it also comes with some risk. Understanding which stock plan is better for you, how it works, and how it could affect your taxes could make you run to a financial advisor for help—or just run away.
A recent survey discovered that around 36% of employees (about 32 million Americans) who work for stock-issuing companies hold shares or options. But ignoring the benefit just because it seems out of reach could equal leaving money on the table. This guide could help you break down your options and decide whether it’s right for you.
First, a Stock Market Appetizer: Alphabet Soup
Navigating your employee stock plans can include a lot of acronyms, words that mean something entirely different anywhere else, or multiple words that mean the same thing.
And one of the keys to confidence could simply be understanding what the heck the document from HR says. In addition, having a grasp of stock-market vocabulary might help you decipher quickly what your employer is offering, the terms and restrictions, and whether it’s a good deal.
What’s a Stock Option, Anyway?
“How do stock options work?” is an easier question to answer once you have a good idea of what a stock option is. The answer is pretty straightforward—it’s an option to buy shares in the future for a price set today. The “option” part means you can buy the stock later if it suits you, but you aren’t obligated.
Unlike an outright stock purchase, an option doesn’t give you actual shares until you decide to buy them, which is called exercising. Another difference from a traditional stock purchase is that options become null and void if you don’t exercise your stock options before the expiration date.
If the company stock has floundered over the years and not produced a return, you can just walk away and the option ceases to exist. But here’s a spoiler alert: If you let your employee stock options expire when the stock price has gone up, you could be leaving thousands of dollars on the table.
The Grant/Strike/Exercise Price
See? Three different words for the same term: the price at which your plan says you can purchase company stock. It’s most often based on the stock’s current market value and is extremely important because it determines whether your options end up winners or losers.
If your strike price is 1,000 shares at $1 per share, for example, that’s what you’ll pay for those shares if you decide to exercise, regardless of their current market price.
When the stock is currently trading above the strike price, it’s called being “in the money” and the profits can be huge.
Conversely, if the stock’s market price falls below the strike price, your options are considered “underwater” or “out of the money” and don’t hold any value. In that situation, it may be cheaper to buy your company’s stock on the open market.
Privately Held, Publicly Traded, and Going Public
If a company is considered public, it’s registered with the Securities and Exchange Commission (SEC) and is approved to offer shares to the public on an exchange. Exercising your options at a public company means you can then trade your shares on the open market.
Many private companies also offer stock options—especially if they’re a startup looking to grow capital. (Check out this interesting case study .)
But because a private company hasn’t gone through the SEC registration process, shares can only be sold privately unless the business “goes public.”
That’s the common term for an initial public offering (IPO), or a private company’s transition to the public market. If you go through an IPO as a private stock options holder, you’ll be allowed to sell your shares on the stock exchange. The rules on pre-IPO stock can be pretty stringent, though.
ESOs: The Grant, the Cliff, the Vest, and the Exercise
Lesson two: How do stock options work? This is where the process, the timeline, and all the rules and regulations that come with options come into play. It’s also where you might start to get a clearer picture of your own situation.
For the most part, ESOs operate via a four-step process.
First, the grant: The grant date is the official start date of an ESO contract. You receive official information on how many shares you’ll be issued, the strike price for those shares, the vesting schedule, and any requirements that must be met along the way.
But typically, all that happens on the grant date is you get some paperwork and the clock starts ticking.
In order to start claiming your stocks, you may first need to survive the cliff.
The cliff: If a compensation package includes ESOs, it doesn’t necessarily mean that they’re available on day one. Contracts often contain a number of requirements that must be met first, such as working full time for at least a year.
Those 12 months, when you’re working but not yet eligible for stock options, is called the cliff.
If you remain an employee past the cliff date (without jumping), you get to level up to the vest.
Next, the vest: It’s not some exclusive company uniform that’s only available to stockholders (although that might be kind of cool.) When you pass your cliff date, your vesting period begins, which means you start to take ownership of your options and the right to exercise them.
Vesting can either be a slow burn over several years or an all-at-once proposition, depending on your company’s plan. One common vesting schedule is a one-year cliff followed by a four-year vest.
On this timeline, you’re 0% vested the first year (meaning you aren’t eligible for any options), 25% vested at the two-year mark (you can exercise up to 25% of the total options granted), and so on until you own 100% of your options. At that point, you’re considered fully vested. (But still no sweet wardrobe, sadly.)
Finally, the exercise: This is when you pull the financial trigger and actually purchase some or all of your vested shares.
Here are some common exercise options for your options.
• You can buy the stock outright, but it might require a hefty chunk of change up front. For example, 10,000 shares at $2 each is a cool $20,000. One advantage to this exercise, however, is that you hold all the stock and are free to do with it as you please on the open market.
• If you don’t have that kind of cash, you can buy and sell all your stock in one breath with something called an exercise-and-sell transaction. In this scenario, your broker essentially lends you the cash to exercise your options, then pays itself back with a portion of the sale profits.
• Another option is to buy all your shares, sell just enough to cover the cost (according to the example above, $20,000 worth), and hold the rest. This is called an exercise-and-sell-to-cover transaction.
One common timeline is 10 years from grant date to expiration date, but specific terms will be in a contract.
The Pros and Cons of Exercising Employee Stock Options
If you land a job with the right company and stay until you’re fully vested, exercising your employee stock options could lead to instant, huge gains.
Especially if, for example, your strike price is $30 per share and now the stock is trading at $100 or more per share. On the other hand, if your strike price is $30 per share and the company is tanking, your options are basically worthless.
But perhaps the biggest downside that comes with exercising employee stock options is now much Uncle Sam can take.
How Can Employee Stock Options Affect Taxes?
Generally speaking, employers offer two types of stock options: nonqualified stock options (NSOs) and incentive stock options (ISOs). NSOs are the most common and often the type offered to the general workforce.
The difference between the strike price and the stock’s value when you exercise your options is considered earned income and added to your W-2, where it’s taxed just like your salary.
Any money you make above and beyond that if you sell your shares later can also be subject to the capital gains tax, which is imposed on profits earned from selling certain types of assets, such as real estate, stocks, or a business.
The capital gains tax doesn’t kick in if you simply own these assets, but it can really bite you if you make money on selling them.
In fact, it could be one reason less than a quarter of workers who were offered equity compensation actually exercised their options or sold their shares.
Here’s how it works: If you hold your shares less than a year, the short-term capital gains tax rate equals your ordinary income tax rate, which could be up to 37% for the highest tax bracket.
For assets held longer than a year, the long-term rate can be 0%, 15%, or 20%, depending on your taxable income and filing status.
ISOs, the second kind of popular stock options, are usually reserved for high-ranking company executives and come with a big tax advantage: They can be exercised in the money without having to pay income tax on the profit. In fact, employees don’t even have to report it as income.
Hold those shares for a year or longer, and you’ll only be held liable for the long-term capital gains tax. But before you get all excited, we need to discuss the alternative minimum tax (AMT).
While ISOs aren’t taxed as income, they could be subject to AMT, which was created to get at least some taxes out of high-income individuals and corporations that otherwise manage to avoid them.
The AMT can be an extremely complicated subject. There are ways to avoid the AMT, but you should consult a tax professional to help guide you through all the rules and regulations that apply.
What Are Restricted Stock Units (RSUs) and How Do They Work?
Restricted Stock Units are also a form of equity compensation, but they are quite different in how they’re granted, vested, and regulated.
RSUs aren’t stock. They aren’t options. They’re something in between—a promise of stock at a later date. When employees are granted RSUs, the company holds onto them until they’re fully vested.
And what determines vestment is entirely up to the company. It can be a time period of several years, a key revenue milestone, or even personal performance goals. To add another layer of complexity, RSUs can vest gradually or all at once.
Another difference is how they’re valued—instead of a strike price, RSUs are priced based on the fair market value of the stock on the day they vest, or the settlement date. This means that you don’t have to worry about falling out of the money.
As long as the company’s common stock holds value, so do your RSUs. One final difference between RSUs and ESOs is that you may be able to settle your RSUs in two ways—in actual shares or the cash equivalent.
The Pros and Cons of RSUs
One good thing about RSUs is the incentive they can provide to stay with the company for a longer period of time. If your company grows during your vesting period, you could be very far in the money when your settlement date rolls around.
But even if the stock falls to a penny per share, they’re still awarded to you on your settlement date, and they’re still worth more than the $0 you paid for them.
In fact, you may only lose out on money with RSUs if you leave the company and have to forfeit any units that aren’t already vested, or if the company goes out of business.
An RSU’s lack of a strike price is sometimes referred to as downside protection. But there’s another big downside to this type of compensation that might sound familiar.
How Can RSUs Impact Taxes?
RSU tax rules are quite different from ESO’s, and understanding these differences can be key for not only deciding which type of compensation is better for you, but how to plan your taxes effectively.
When your RSU shares or cash equivalent are automatically delivered to you on your settlement date(s), they’re considered ordinary income and are taxed accordingly. In fact, your RSU distributions are actually added to your W2.
Another aspect to keep an eye on with taxing RSUs as income is whether the amount will bump you up a tax bracket (or two.) If you’ve only been withholding at your lower tax bracket before your vesting period, you could owe the IRS even more.
And finally, if you accept shares vs. the cash equivalent, you’ll then be subject to capital gains taxes if you sell them for a profit at a later date.
One bit of good news is that, as part of the 2017 Tax Cuts and Jobs Act , some private companies may offer deferment of income taxes on both stock options and RSUs for up to five years.
I’m Fully Vested! Now What?
So you’ve done your time, your company stock offerings have vested, and now they’re making money. What’s next? Do you immediately exercise your options, take the money and run, or let it ride in hopes of even further growth?
One school of thought is to sell your shares on the same day you receive them. If they are RSUs, you’ll still be subject to income tax but may avoid capital gains.
Another approach is to lay out your optimal timeline for cashing out. For example, there are several ways to offset your capital gains tax if you time the sale of your shares with either capital losses or other tax deductions. This is sometimes referred to as tax-loss harvesting.
While RSUs automatically convert to shares on the settlement date, you can hang onto your ESOs for longer if you feel like the company’s stock price is doing well.
And, because you don’t have to pay income taxes on ESOs until they become shares, holding onto them could also delay that payment.
There are several risks with this strategy though, including forgetting the expiration date and forfeiting all your options, or watching the company stock take a turn for the worse and dip below your strike price.
It’s a lot to consider. And for some, it may seem like more trouble than it’s worth. A recent study revealed that, of 1,000 employees who received equity compensation, less than a quarter of them have exercised their options or sold shares.
The driving factor for many of them? Fear of making a mistake, either by selling under the wrong market conditions or ending up with a huge tax bill.
If these fears are rolling around in your mind as well, the best course of action might be to consult a financial professional who might help you get the best return on your equity.
And if you want some guidance without paying exorbitant fees, you could consider opening a SoFi automated investing account. SoFi offers competitive wealth management with low cost funds, no administrative fees, low account minimums, and extensive access to a team of credentialed financial advisors.
Diversification May Bring Confidence
No one can predict the future, and nothing is a sure bet—just ask the folks who worked at Enron. Because of this, many financial advisers recommend that no single stock should represent more than 10% to 15% of your portfolio, and some cap it at only 5%.
Going above that, especially with your company stock, could put you at risk for the double whammy of losing both your salary and your stock if the business goes belly up or gets racked by scandal.
One good way to avoid the pitfalls of putting all your eggs in one basket is to buy more baskets. Portfolio diversification means distributing your money across areas that aren’t likely to respond to financial happenings in the same way. And while it won’t completely erase vulnerability, it can go a long way to reducing it.
Investing in ETFs with SoFi Invest® could potentially help diversify your portfolio by investing online in a variety of stocks for a fraction of the cost.
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