Equity compensation can be a powerful wealth accelerator on your path to financial freedom.

It offers the potential for greater upside than a traditional salary since the value of your equity can increase substantially if the company does well. In addition, it can allow you to benefit from the success of the company while limiting your risks.

But you have to know what you’re dealing with. 

Lyndon L. Davis, WMS, CRPC^TM, Senior Vice President at Lyndon Davis Wealth Management, Raymond James & Associates Inc., member New York Stock Exchange/SIPC suggests the following. However, keep in mind that Raymond James and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional. 

“When looking at your stock options, it’s important to remember the 3 T’s. The three T’s are as follows: 

1. Type. What type of equity do you have? Each type of stock, from NSOs, ISOs, RSUs, restricted stock, performance shares and phantom equity has its own set of rules and regulations, so it’s important to understand the terms of your award before you make any decisions. 

2. Term(s). Most equity compensation awards have vesting terms or a vesting schedule, which means that you won’t be able to sell your shares until you have met a certain criteria. This can be a good thing as it forces you to hold onto your shares for a certain period of time, even if the stock price declines in the short term. 

3. Taxes. When you sell your equity compensation, you may have to pay capital gains taxes. Sometimes, depending on the type of stock you have, you may have to pay taxes on that as earned income as well, even if you do not sell your shares. So make sure to carefully review the tax consequences of the type you get.”  

Equity compensation can be complex and risky, causing some to unknowingly put their future financial success at the mercy of their employers. Not to mention the tax considerations that come with it, from unexpected tax bills and confusing rules to the overwhelming complexity of alternative minimum tax (AMT).

"Many people face unexpected surprises due to confusion around the tax consequences associated with Incentive Stock Options (ISOs)," says Mark Cecchini, CFP®, a financial advisor at Compound. In some instances, they may be obligated to pay taxes before even selling the stock due to Alternative Minimum Tax (AMT) requirements. This can lead to unanticipated tax liabilities in the five or six-figure range, putting diligent employees in a difficult predicament when they lack the required cash to cover big tax bills prior to their stock becoming liquid," Mark continued.

So, when evaluating your options, it's essential to be informed, do your research, and don't hesitate to consult the help of a trusted financial advisor. Because at the end of the day, to do well with your equity compensation, you need a plan.

Also, it doesn’t hurt to ask the professionals about these types of stocks, as they are quite different than the typical compensation that you would receive from your employer.

“When you receive some form of stock or options from your company, it’s important to understand the plan,” says Dan Hattori of AdvisorCheck. “Your company’s human resources department should provide documentation explaining the details of the stock compensation you will be receiving. If you need additional help understanding the documentation, we implore you to seek out an HR representative, a work colleague (if most employees receive this type of compensation), a financial advisor or an accountant,” Dan continued. 

“Once you understand how the stock compensation plan works, follow its value the best you can. If your company is a public company, you can follow the price of your company’s stock in the public stock market. If your company is private, it will be more difficult to track this, but ask your company’s management for updates on a regular basis. It is probably best not to assume that the company’s stock has significant value, unless there is specific knowledge of the actual price,” Dan further expressed.

Restricted Stock Units (RSUs)

What Are Restricted Stock Units (RSUs)?

Restricted stock units (RSUs) are a form of equity compensation where a company grants its employees shares of the company's stock, which become available to them after meeting certain vesting conditions.

With RSUs, vesting is everything. Vesting is the process of when you can access your RSUs. In other words, it's when they become yours — when they are vested. Generally, there are three main types of vesting schedules:

1. Time-based (vesting occurs over a certain period)
2. Performance-based (vesting occurs when you achieve certain goals or milestones)
3. Cliff vesting (all of the RSUs vest at once)

Vesting schedules will vary by company, so it's important to know your specific employer's policy.

Most importantly, if you leave the company before your shares have vested, you will forfeit any unvested shares. That's why it's critical to plan ahead and understand the specifics of your vesting schedule.

Tax Rules for RSUs

Like many other forms of equity compensation, the tax rules for RSUs can be complex. 

That's because there are many different rules that can apply in different situations. And, there are certain elections you can make to receive different tax rules based on your planning needs. To ensure you get the best tax outcome, consider hiring a trusted advisor specializing in equity compensation planning.

All that said, at a high level, here's how RSUs are taxed before and after your shares are vested.

1. Before your shares are vested. Generally, before your shares are vested, there are no taxes due on your RSUs. And it makes sense — you don't own them yet, so you don't pay any taxes yet.
2. After your shares are vested. Once you meet the vesting requirements and gain ownership of your RSUs, you report income equal to the value of the shares at the time of vesting. All of that income is taxed at your ordinary income rates, just like wages you receive from your employer.
3. When you sell the stock. Once you own stock, you can sell it or hold it. If you sell, you pay capital gains tax on the profit. If you sell within a year, it's a short-term gain. After a year, it's a long-term gain.

But here’s where some can get an unexpected tax bill.

Just because your RSUs vested and you had to report taxable income does not mean you have any extra cash to cover the tax bill. In other words, you have to report the full amount of the vested RSUs on your tax return and pay taxes, but you don’t have any additional cash from the RSUs vesting to cover the taxes.

So, you must plan ahead and create a strategy to cover your tax bill — either using outside cash to cover the withholding requirement or selling some shares at the time of vesting to cover the taxes. Otherwise, you could wind up in a situation where you’re scrambling to come up with some extra funds on tax day.

To understand the potential value of RSUs and the tax treatment you can expect, consider an example. 

You receive an RSU grant of $15,000 with a 1-year vesting schedule. After 1 year, they vest and are worth $20,000. You pay taxes on the full $20,000 at your ordinary income tax rates. If you sell the stock for $27,000 over one year later, you have a long-term capital gain of $7,000.

Ultimately, RSUs are a great way to supplement your income and build wealth over time. When it comes to taxes, understanding the difference between compensation income and capital gains can help you plan and maximize your tax savings. With proper planning, you can be sure to optimize the value of your RSUs.

Stock Options: ISOs and NSOs

What Are Stock Options?

Stock options give you the right to purchase your company stock at a predetermined price.

They're great because they limit your risk while providing a powerful upside. If the value of your company's stock goes up over time, your stock options can pay off big. But, if the value of your company's stock goes down, you haven't lost anything, you just wouldn't exercise your stock options.

Understanding The Difference Between ISOs and NSOs

Stock options come in two types: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs).

ISOs are only available to employees (not subcontractors), and they provide tax advantages that are not available with other types of options. These include the ability to defer taxes on the gain until you sell the stock and qualification for capital gains tax rates instead of ordinary income tax rates.

NSOs don't have the same tax benefits as ISOs. Taxes must be paid on the gain when the option is exercised, and the spread between the exercise price and market value at that time is taxed as ordinary income.

One of the most important things you can do when creating a plan for your stock options is to understand whether you have ISOs or NSOs. If you are unsure, ask your employer for a copy of your "Option Agreement," which clearly outlines if you have ISOs or NSOs.

Tax Rules For Stock Options

Understanding how stock options are taxed can help you make decisions about when to exercise them for optimal tax efficiency. It's important to consult a knowledgeable financial advisor or tax preparer who can review your specific situation and help you plan accordingly.

The tax impact of stock options depends on how they are structured and when they are exercised. Generally speaking, exercising non-qualified stock options (NSOs) is treated as taxable income. When you exercise NSOs, the spread (the difference between the exercise price and the market value of your stock) on that date is considered ordinary income, and it's subject to ordinary income taxes.

On the other hand, exercising incentive stock options (ISOs) may not be subject to any tax at the time of exercise, though there are certain instances where it will. However, you will need to report the spread when you sell your shares, which will trigger capital gains taxes. To get favorable long-term capital gains treatment, you must hold the stock over one year from the date of exercise and two years from the grant date.

Fortunately, because stock options provide an option to buy, not a requirement, it is possible to manage your risks. 

That said, you could face a hefty tax bill when you exercise NSO options, even if you don't receive any cash to pay the tax bill. Again, this is where it's critical to plan ahead and strategize how you'll cover that bill. Typically, you can choose to cover the tax bill with outside cash savings, or you may decide to sell some of your stock at the time of exercise to cover the tax liability.

In addition, there are some very complex and tricky tax traps when exercising ISOs that could lead to a large alternative minimum tax (AMT) bill. AMT is an additional income tax imposed on certain taxpayers who have a high amount of taxable income or who exercise incentive stock options. It doesn’t apply in every instance, but it’s something to be aware of. 

For example, according to Kaye Thomas, author of Consider Your Options: Get The Most From Your Equity Compensation, sometimes you can get caught in a tax trap and may need to ‘bail out’ on your stock options. 

He writes: “You exercised an incentive stock option with $1,000,000 of profit early in the year. It turned out to be a disastrous year for your company, and toward the end of the year the stock is worth $200,000. If you continue to hold the stock, you’ll owe $280,000 in AMT — more than the value of your stock. If you sell before the end of the year, you still have sales proceeds of $200,000 and your taxable income is limited to your actual profit (if any). ‘Bailing out’ reduces your taxes by over $200,000.”

This is a prime example of how critical it is to understand the rules, have a game plan, and be willing to adjust as needed. And, of course, this is when a trusted advisor can be well worth it as they can help you avoid a significant tax bill.

Employee Stock Purchase Plans (ESPPs)

What Is An Employee Stock Purchase Plan?

Employee Stock Purchase Plans (ESPPs) are a type of stock purchase plan employers offer to their employees. Typically, these plans allow employees to purchase company stock at a discounted rate.

Understanding The Difference Between Qualified and Nonqualified

They come in two types: qualified and nonqualified. The key difference between the two types is how they are taxed. Qualified ESPPs are more common and receive favorable tax treatment, whereas nonqualified plans have fewer tax advantages and are less common.

How ESPPs Work

ESPPs are unique in the way they function. Details vary by plan, but at a high level, this is how they work:

1. Your employer gives you the ability to purchase company stock at a discount.
2. If you want to opt in, you must sign-up by a certain date, known as the election period.
3. You can elect to have a specific percentage of your paycheck withheld to purchase that stock (between 1 and 10%.)
4. Then, money accumulates each paycheck for a period of time, known as the offering period.
5. At the end of the offering period, your money is used to buy stock at a discounted price.

Tax Rules For ESPPs

Like other forms of equity compensation, ESPP tax rules can vary based on your situation. 

Most importantly, nonqualified and qualified ESPPs are taxed differently. Generally, with nonqualified ESPPs, if you got a discount on the stock, you have to report that as ordinary income and pay taxes on it. Then, when you sell the stock, you can be subject to long or short-term capital gains depending on your holding period.

Alternatively, with a qualified ESPP, you don't have to report any income when you receive the stock, even if you got a discount on the stock, but you do need to meet a special holding period. It's the same as ISOs: one year after you received the stock and two years after the start of the offering period.

Assuming you meet the special holding period, you should not need to pay any taxes until you eventually sell the stock. That said, this is merely scratching the surface of the various tax rules that apply to ESPPs. So, be sure to consult with a trusted advisor or tax planner when devising your strategy.

In summary, ESPPs can be a great way to save money on taxes and build long-term wealth through stock ownership in your company. But, they have unique rules and require thoughtful planning to execute a successful strategy.

Phantom Stock

What Is Phantom Stock?

Phantom stock is an agreement between an employer and an employee in which the employee has the right to receive a payment based on the value of the company's stock without actually owning any shares. Instead of granting actual shares, the employer gives the employee a right that follows the value of a specific number of shares.

The employee will be entitled to a payout equal to the value of the tracked shares. Payouts typically occur on a predetermined date or when certain events occur, such as retirement, disability, sale of the company, or death. If the employee leaves the company before the phantom stock vests, they usually lose the right to the phantom stock.

Phantom stock plans can offer a single payment or installment payments over time after the stock vests. In some cases, the employer may allow the employee to choose between receiving the payout in cash or equivalent shares of stock. Some phantom stock plans also give employees payments equivalent to any dividends paid to shareholders.

Ultimately, phantom stock plans offer employees a sense of ownership and incentive to remain loyal to the company, while providing employers with a cost-effective way to reward their staff.

It is important for employees to understand the specific terms and conditions of their phantom stock plan and consult an advisor to develop a solid plan to maximize their benefit.

Types Of Equity Compensation At Major Employers Like Google

Major employers like Google offer a range of equity compensation programs to their employees. These include popular options such as incentive stock options (ISOs) and restricted stock units (RSUs).

Google is well-known for its RSU-like program, which it refers to as GSUs (Google Stock Units).

At a high level, GSUs operate very similarly to a typical RSU program, with the key differences being how shares vest. With Google's program, shares can vest faster based on your performance. In other words, the better you are at your job, the faster you get ownership of your Google shares. This creates an incentive for employees to do their best work.

Overall, these types of equity compensation programs help major employers like Google create an environment that rewards hard work and aligns the interest of employees with that of the employer.

Ultimately, equity compensation plans, including restricted stock units (RSUs), stock options, employee stock purchase plans (ESPPs), and phantom stock, can be powerful tools for building wealth.

However, understanding the complexities and tax implications is crucial to maximizing your money.

RSUs, for example, require knowledge of vesting schedules and tax rules before and after shares are vested. Stock options, such as ISOs and NSOs, come with different tax treatments and considerations. ESPPs can provide discounted stock purchase opportunities with varying tax rules based on qualification. And phantom stock offers employees similar benefits to owning actual stock without the ownership itself. Lastly, major employers like Google have their own unique equity compensation programs, such as GSUs.

To navigate these options effectively and minimize risks, it's important to consult a trusted financial advisor specializing in equity compensation planning. 

By utilizing our proprietary “Advisor Search” tool, individuals can connect with experienced professionals in their area who specialize in equity compensation planning and ensure their financial success. 

Take control of your equity compensation and secure your financial future by signing up for your free membership today.

Written by Anders Skagerberg, CFP® 

Fact checked by Luke Jara

Reviewed by Leonard Kim

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