What is equity compensation? Learn about restricted stock units (RSU), non-qualified stock options (NQSO), incentive stock options (ISO), employee stock purchase plans (ESPP) and more in this webinar with financial advisor Ian Barr, CFP®, MBA from Pure Financial Advisors. Ian explains time-based vesting, performance-based vesting, tax treatment, the life cycle, and benefits of the various types of compensation benefits, and he answers viewer questions.
Outline
- 00:00 – Intro
- 00:34 – What is equity compensation? Most Common Types
- 01:44 – Restricted Stock Units (RSUs)
- 09:14 – What is single vs double vesting RSUs? And what type of events trigger the second half of double vests?
- 10:04 – How is the RSU value determined?
- 10:50 – Are Restricted Stock Awards (RSAs) the same as RSUs? What’s the difference?
- 12:23 – Stock Options
- 19:35 – Incentive Stock Options (ISOs)
- 21:55 – Are taxes due at issue of the shares? What are the tax implications of stock options?
- 24:48 – What records does one need to keep so they’re prepared once they sell their shares?
- 26:06 – Employee Stock Purchase Plans (ESPPs)
- 34:17 – You mentioned strike price and exercise price, are they the same thing?
- 34:54 – Both RSUs and options, if I were to sell some of the shares, which do you recommend I sell first?
- 36:09 – I’ve heard of Stock Appreciation Rights (SARs) are a lot like options. What’re the differences?
- 37:47 – Can you explain how to make sure you have a qualifying disposition of an ESPP stock?
- 40:33 – What happens to my unvested stocks if my company either gets acquired or goes out of business or if I leave my company?
- I heard that equity compensation is mainly offered to employees in the tech industry. Do you expect it to expand to other sectors?
- What considerations should I take into account when incorporating equity compensation into my overall retirement plan?
- 44:55 – Pros of equity compensation for employees
- 45:17 – Cons of equity compensation for employees
Transcription:
Kathryn: Thank you for joining us for this Equity Compensation Basics webinar. We are so happy that you’re here and we have Ian Barr, CERTIFIED FINANCIAL PLANNER™ with Pure Financial Advisors. Ian, we’re very excited. We know you have a lot of information to share with us.
Ian: Thanks everybody for joining. Appreciate it. My goal was really just to provide a working understanding of your equity compensation so that you can make informed decisions around your finances. And as always, we’re here to help if you need anything along the way. But with that in mind, we can start off with the most basic of questions, right?
What is equity compensation? Equity compensation is a form of compensation that offers employees ownership in the company they work for. Typically employers like offering equity compensation to their employees because it attracts and retains quality employees and aligns their performance with the goals of the firm. Employees like equity compensation because they have a chance to participate in the overall growth of the firm by having an ownership stake in the business. So there’s quite a few types of equity compensation plans or stock plans. In fact, while there are some consistencies across the board, each stock plan is basically unique in terms of structure and the rules that govern the plan. But for today’s discussion, we’ll talk about the most common terms and types of rewards here. So, the most common here looking at restricted stock units or RSUs. Stock options, two varieties there, the non-qualified or stock options as well as incentive stock options. I incorporate the acronyms here because these are frequently used shorthand for a way to describe these awards. Finally, we’ll end with employee stock purchase plans or ESPPs.
So first up, we have restricted stock units, or RSUs. The simplest way to think about this is that a company is just really giving you shares of their stock, right? The restricted component just refers to the fact that you typically don’t get them all at once, thereby restricting your access to the ownership of the shares. So, let’s just start off with a couple of key terms on this. Grant date is basically when you’re informed that you’ll be receiving shares of the company’s stock. The company is determined that based upon the stock price currently, they want to give you X amount of shares for your hard work. You can think of the grant date as the starting point for some measurement as it relates to the vest date. And the vest date is when you actually receive the shares. The shares become yours. You take ownership of them and you typically get to do what you want with them at that point. But typically, you know, some higher level executives within the firm might have certain restrictions on their shares, even after they vest, but for most people, you get to do what you want with them once you, once they vest. There are typically two types of vesting available. One is a time-based vest, the other is a performance based vest. Some, some plans actually offer a combination of the two, but let’s first, let’s take a look at this time-based vesting example here.
This slide illustrates a vesting schedule that shows the granted shares vesting evenly over a 4-year period. Let’s say you’re granted 1000 shares over a 4-year vest schedule. You’d get 250 shares, vesting in the 1st year, 250 shares in the 2nd year, and so on until you get all of the grant by the end of the 4th year. Obviously, this incentivizes employees to stay with the company longer to receive those shares, particularly if the stock has grown significantly over time. But, key to note here is, if you were to leave the firm before the shares have vested, you typically lose the unvested shares. So if, that’s a, that’s a key component. If you’re thinking about switching jobs, obviously, and another note here, if you are approaching retirement, it really makes sense to have a discussion with your HR representative to see if you qualify for accelerated vesting, for example. There are a lot of companies that will push forward your vesting schedule based on the number of years you’ve worked with the firm, for example. So, it’s good to know the rules around your particular stock plan so that you can optimize your retirement date. Make sure you collect as many of those shares as you can before retiring. Next up, we have a performance-based vesting example. Performance based vesting, there’s a variety of metrics that can be used for performance-based vesting. The typical metrics include things like earnings per share growth of the company or relative stock performance compared to a company’s peer group. Typically, what happens is there’s a share quantity that’s granted at the grant date. And then there’s a specific measurement period that happens maybe a one or two or 3 years later, where a measurement is made on the earnings per share growth or the stock performance and, subsequent vest amount is given or received by the employee accordingly.
So, for example, in this, this case, just as a hypothetical here, the company could say if the company has earnings per share growth between 8% and 10%, you get, you know, 100% of your initial grant amount. If the company’s earnings were above that, let’s say over 10%, for example, you could get a multiplier effect on your initial share grant. You could potentially get 200% of the initial grant amount. But conversely, on the other side of the coin, if the company does less than 8% earnings per share growth, the employee could get 0% of their initial grant amount. So, it’s really designed to be structured around the performance of the company, and it aligns, you know, the amount of equity or shares that you receive based on those metrics, and companies can get pretty, pretty creative around that. They have a variety of different things that they can use to incentivize what they’re focusing on. Sometimes you’ll hear these types of awards called PSUs or performance share units. They’re basically the same thing as a RSU. They just, you know, some people will use that terminology to make the distinction, distinction between the types of, of, awards that are offered.
So, yep, what does this mean in terms of your taxes, right? So, for these types of awards, there’s no consequence on the grant date. So when you’re told that you’re getting these shares, there’s no tax implication there. However, there is a taxable event upon vesting. As I mentioned before, vesting is when you actually take ownership of the shares. And therefore, it’s considered compensation received and consequently taxed at ordinary income tax rates. There can be a variety of ways that taxes are withheld for you upon shares vesting. It’s probably not worth getting into some of those details, but it’s good for you to understand how your company, withholds those shares, withholds taxes for you. Because for a variety of factors, companies will typically withhold a flat 22% on your federal tax when they vest, when shares vest, regardless of the actual tax bracket you’re in. So, and it’s because of administration around that. And, this kind of falls within, an accepted IRS constraint there. But if you are one of those people that’s in a higher tax bracket, in a lot of cases, you might have, not have enough withheld for you at, at vest. And so you might end up owing a little bit more in taxes when it comes to filing. When, let’s see, when taxes are withheld at your vest date, you establish something called a cost basis in the shares. It’s the fair market value of the shares that you received on the vest date. So in this example here, the share price on the vest date is $40 per share. You received 100 shares of the stock. You paid $4000 worth of compensation on the vest date. You pay taxes on that, that $4000 worth of compensation. That $40 per share stock price will be using calculating the gain or loss on the shares at the time you sell them. So if the stock price in this example goes to $100 per share when you decide to sell, you’ll be responsible for paying taxes on the $60 per share gain. The amount of taxes you owe on that $60 depends on how long you held the shares before you sold them. If you sold the shares a year or less after the vest date, you’ll be responsible for ordinary income taxes on that gain. If you held the shares longer than a year, you’ll be responsible for long term capital gains at, or taxes at the long-term capital gains tax rate, which, as many of you know, is a more favorable rate when compared to ordinary income taxes. So it’s definitely important to keep in mind, how long you’ve sold or how long you’ve held the shares prior to you selling them. It has pretty significant tax consequences there. Any questions on RSUs we can address there? That’s pretty straightforward.
Kathryn: There’s one that says, I’m not sure if we’re going to talk about it, but they would love to hear about single versus double vesting RSUs and what kinds of events trigger the second half. Does that make sense to you? Of double vests.
Ian: Single versus double vest. Again, these, these stock plans can be very unique. They can actually structure these things in a way such that, you know, the vesting will occur based upon certain conditions being met, right? It could be the performance. It could be time. It could be some combination of the two. You’d have to, I would have to know more about your specific plan before I kind of really chimed in on that. We can definitely take a look at that between, you know, your Pure Financial Advisor. We can, or, you know, if you’re not working with us already, we’d be happy to take a look at that for you to make sure we get you the right information.
Kathryn: All right. And then how is the RSU value determined?
Ian: So it’s, it’s the fair market value at the time of vest. So if the stock is trading at $40 in that example, that is, that is how it’s, it’s valued, right? So, and that establishes the cost basis. Typically what companies will do is either they’ll, they’ll usually take the closing value on the day of vest. So the closing price for the market, right? Some will do an average of the, you know, high and low of the day, things like that. So again, you know, companies can get pretty specific and make things unique for their own employees and awarding them these stop plans or these equity competition.
Kathryn: And then are RSAs the same as RSUs, or what’s the difference?
Ian: Yeah, it’s a, it’s a, it’s a slight difference there. It’s, it’s RSAs, restricted stock awards. They very, very similar to RSUs in that you get a grant. But what they do is basically they kind of allocate the shares to you. So in some, in for RSAs, you can typically, they basically meter them out to you and then you earn them over time. It’s, it’s a little bit different. You’re not really actually given the shares in RSUs. You earn them over the vest. RSAs, you’re kind of like allocated the shares and the restricting is lifted over time. But when you have RSAs, you have the ability to potentially earn dividends off of those shares, you don’t necessarily own at that point. You don’t pay taxes when you, at the grant. When you have RSAs, you could potentially, like I said, earn the dividends or have voting rights on those shares that you haven’t owned yet. There is, RSAs also allow for something called an 83B election, which you, where you can proactively elect to have those shares taxed at grant. And if you anticipate those shares to grow significantly over time, maybe it’s a better strategy is to go ahead and pay taxes on the smaller amount in the anticipation that it grows over time. But, you want to be careful there because, you know, if you, if again, if you leave the firm early, you don’t get a rebate on that, on that early, tax payment.
Next, I want to talk about stock options. There’s two types of stock options, as I mentioned before. Non-qualified stock options, sometimes referred to as non-Quals or NQSOs or non-statutory options, NSOs. There are incentive stock options, sometimes referred to as ISOs. Most common of these two is non-qualified options, but we’ll touch upon incentive options, incentive stock options as well. Before we get to the, some of that detail, let’s, let’s go through this definition here. An option is the right to buy a share of stock at a certain price. There’s no obligation to buy the shares at that price. It just gives you the right to buy those shares at a predetermined price. Which is sometimes called the strike price, but more often called the exercise price. Options have a limited shelf life, so you only have the right to buy or exercise for a limited time. Before we dive into some additional key terms, let’s first recall the grant date and vest date as both of those terms apply here to options as well. Same concept as RSUs. As we mentioned earlier, the stock options are granted at a certain date. There’s no tax consequence when they’re granted. It just means that you’re notified when you’re going to receive those stock options. The term vesting also applies in the same way with stock options, but with a twist with respect to taxation, which we’ll talk about in a moment. However, like RSUs when options vest, that’s when you take ownership or receive those options. So, I touched upon the term exercise price a moment ago. I just want to add on the terms exercise price and expiration date. Exercise date is the day you decide to buy shares at the exercise price. You can think of it like you’re exercising your right to buy the option at the predetermined price. The expiration date is just as it sounds. It’s the last day you can possibly buy the shares at the exercise price. Important to know here, similar to RSUs, if you leave the company prior to your options vesting, you typically lose those unvested options. The thing to remember here is that even if you have vested options, you will typically lose the right to exercise those options within 90 days of leaving a firm. Although, again, stock plans can vary on those rules. So, it’s something to keep in mind, again, if you are looking to switch firms or potentially retiring. Those are typically rules around even vested shares or vested options, excuse me. I think this next slide just kind of orients you on the timeline here and sequence of events on stock, on stock options again, grant, when you’re notified, and the starting point for the, or the vesting calculation, however that works, options vests, you can potentially exercise and then there’s a sale. And again, we’ll kind of walk through an example. So, say your company grants you options to buy the stock at $50 a share. The exercise price is typically set at the fair market value of the shares at the time of grant. So, over time, the options vest and you have the ability to exercise them at any point after the vest. And again, by exercise, I mean you can buy the shares at the exercise price any time after they vest. So, you know, in looking at this, stock price has moved up from the original grant date. $50 a share is when the, you know, the options were granted. The stock price is now trading at $70 a share. And so you might think, great, you know, this is, I can get this stock that’s currently $70 for just $50 a share. And you just bought your stock sort of on sale, right? You paid $50 for something that everybody else is paying $70 for. So, that’s, an example of when, you know, stock prices are up.
Now, if we look at an example that where the stock price goes the wrong way on you. Sometimes people refer to this as being underwater. These options are underwater, or in the previous example, in the money. So you have intrinsic value there. In this case, you, say for example, again, the $50, per share. Is, now trading at $40 per share, you know, obviously you wouldn’t want to pay something, pay $50 for something that you could actually go out into the market and buy for $40 a share, right? So, you’d be paying more than the market price, and in this example, you know, you’d just kind of hang on to this option. And hoping for an increase in the price over the exercise price. And by doing this, you know, there has been no tax consequence throughout this. You know, if you were granted these options at $50, they vest, the stock price is below the exercise price. You’re still hanging in there. There’s no tax consequence at this, throughout this. So, speaking of tax consequences, let’s just walk through kind of the basic, non-qualified, example here. Again, so, let’s, let’s go back to the stock price where it was up, it moved in the right direction for you, right? So, the, the, the exercise price again is $50 per share, it’s currently trading at $70 a share. Well, the $20 gain that you would have gotten by exercising is, is taxed at ordinary income for the year of the exercise. So that, that $20 is considered a bargain element or the benefit you received as part of your overall compensation package. So in other words, as a part of your compensation, you got a deal on the purchase of the stock.
So that deal is taxed like the rest of your wages, right? So, at exercise, you pay ordinary income tax on that bargain element. Then at that point, your cost basis in the shares that you purchased at $70 a share, because you paid $50 and then you paid taxes on the $20 gain immediately, the $70 price is now used to determine the overall gain and loss when you eventually sell those shares. So, for our example, you exercise those options when the market value was $70 and then you sold those when the price reached $100 per share. You pay a capital gains tax on the $30 gain at the sale of the shares. But like we described previously, if you, if you sell the shares within a year or less after the exercise, you’d pay short term capital gains tax, which is again, ordinary income tax rates. And if you sell the shares after holding them longer than a year, then you’d be responsible for the preferential long term capital gains tax treatment, which again, better than paying more ordinary income. ISOs are basically the same as non-Qual or NQSO options. Really, the main difference is their tax treatment. Their function, their mechanics, the timeline, they’re all the same, except for the tax treatment is different based upon, you know, whether or not you adhere to certain rules in the timeline.
So, let’s take a look real quick at the next slide here. This slide basically outlines, what’s called a qualifying disposition. This is what you need to meet both of these components, in order to get the preferential treatment. So, the real advantage is when you sell your shares, from an options exercise more than a year from the exercise date and more than two years from the grant date. If both of those conditions are met, you’ll be responsible for long-term capital gains on the sale only. The gain is calculated based on the price you paid or the exercise price, so effectively you might not ever have to pay ordinary income taxes on these ISOs. However, you do, if you do not wait, you know, to sell the shares at least one year from exercise and two years from the grant date, it’s called disqualifying disposition and the transaction is effectively taxed like a non-qualified option as described earlier. So bottom line, if you’re not careful here, then you can eliminate the tax advantages of an ISO just by not adhering to the timeline. So, perfect. We have this, ISO, tax treatment here. So let’s see. In our previous non-qual example here, again, going off of the stock price being $70 per share, you decide to exercise the option to buy the shares at $50. For ISOs, there’s no tax consequence in the year that you exercise them, so you don’t have to pay ordinary income tax on the bargain element, as we saw in the non-qual example. However, you should keep in mind that when you exercise ISOs, it’s considered a preference item, with respect to calculating AMT and as you may know, AMT or alternative minimum tax, it’s, a parallel calculation in determining taxes and really with the intent of AMT is to, make sure that higher income earners pay some minimum amount of taxes, but that’s sort of another subject for another day. Just something to keep in mind there.
Kathryn: There was a question wanted more, a little more detail. So taxes due at issue of the shares and the additional, so can you just- there’s no taxes do when you’re when you receive the bonus from your boss. So kind of just-
Ian: So when these things are granted, anytime you receive a grant, there’s typically no tax consequence, you can elect to have them taxed if you wanted to in certain cases. Not worth getting into here, but at grant, there’s typically no tax consequence whatsoever. When these things vest, like when RSUs vest, you actually get ownership of those shares, and therefore there’s, you know, tax treatment, you know, you pay taxes, ordinary income taxes on those. Options are not the same because there’s you haven’t, there’s no, you haven’t exercised anything yet. You’ve just received the option, the ability to buy shares at a certain price. There’s no, there’s no, tax consequences until you actually exercise options. So the vesting on options, there’s no, there’s no tax on the vest of options.
Kathryn: You haven’t gotten anything yet. You haven’t gotten any money from it. I mean, you’ve received it. You haven’t- So. But someone had a misunderstanding because they’re feeling like you’re being double taxed on RSUs, once at the vesting date at ordinary income and then capital gains on the gain. So will you just, remind us how you’re, you’re taxed on kind of the phantom income and then you’re the capital gains.
Ian: Yeah, it is. It’s, it’s, it does sound like the double taxes, doesn’t it? It’s you, when you get RSUs at vest, like I said, it is considered like compensation to you. You pay taxes on ordinary income. You establish a cost basis, which is again, just basically says, the government has said, okay, you’ve paid taxes on this compensation. Okay. It’s gone through the tax ringer. You own these shares. This is an asset for you now. And then, you know, you could sell that a day later. And if there’s a gain on that a day later, guess what? You’re going to pay more on the gain, you know, ordinary income taxes. So it’s, it’s taxed at the same rates. It’ll be your ordinary income tax rates. If you sell that asset, those RSUs, those shares, a year or less from the time that they vested. But if you wait longer than a year, you’ll have the better tax treatment, which is, you know, 0%, 15% or 20 plus %. Most people fit in that 15% bucket on long term capital gains tax rates, which is across the board, any of those 3 stages or levels is better than the ordinary income tax rate. But you’re right. You are get you are getting taxed when you receive or, you know, or when those shares vest and then based on the gain or loss from there.
Kathryn: And then one quick last question about this section. What records does one need to keep? Because when they are paid dividends or they get they’re paying taxes on certain awards, what should they make sure that they have on hand so that when they do sell their shares?
Ian: Yep. It’s a good question. So I always advise clients to keep their confirmations on those. Your confirmation is going to have more detailed information than your statement typically. So your statement might say that you were awarded 1000 shares in March, right? Usually there’s a confirmation that is associated with it. It will show you the fair market value and the fair market value on the date that you receive those shares, that’s what’s, you know, used as a, as a part of your overall compensation number. And that’s what’s going to be taxed. So hang on to your confirmations on either the vest or the transaction itself. If, you know, they’re doing withholdings, that’s where you’re going to have, you know, the, the information you need, because a lot of times at the end of the year, you’ll get a 1099 that has zero basis on it, right? Well, you have to go kind of go back and, you know, calculate what the fair market value was. If you just have those confirmations and save those on each of those vests, you’ll have that ready for you when you, when you file your taxes. That’s a good question. It’s not always there on the 1099.
Kathryn: Okay. Well, let’s go to employee stock purchase.
Ian: All right. So, yeah, ESPPs, allow employees to choose to buy shares of the company stock, typically at discounted prices. There are two types of plans, qualified or Section 423 plans and non-qualified. We, we like using a lot of qualified and non-qualified, terminology, right? It’s really as it relates to IRS regulations and things here, but, more often than not you’re going to be participating in a qualified or section 423 ESPP plan. That’s been my experience. The majority of these plans are qualified plans. And so that’s what we’ll focus on today. Just as far as the ESPP timeline, with all equity compensation awards, companies, board of directors will decide what’s appropriate for their company and in that process, they can decide whether or not it makes sense to offer, you know, employees an ESPP plan. They set them up by announcing an offering period where eligible employees can buy shares at discounted prices. These offering periods are typically one to two years in, in duration, but they can also write these plans up so that they’re sort of evergreen or ongoing. They can offer, you know, the company stock at these discounts as a part of the ESPP on an ongoing basis. First step really is, again, you’re choosing to potentially participate in this. This is not something that’s just given to you. You know, as an employee, you’d have to enroll into an ESPP plan, to be included. At that time, obviously, you agree to the terms and conditions set forth, and you set a percentage of your paycheck that you’d like to have set aside for the upcoming purchases. So, these contributions that you make to the ESPP plan are made after tax from your paycheck. So these, this money that accumulates from your paycheck accumulates until the purchase date in this example here, the purchase date is the, is the obviously the first purchase of the offering period. So, if we advance a slide here, we can take a look at an example of a 15% discount here. So let’s, let’s say the typical example here with a 15% discount on the purchase. We’ll assume that you have already enrolled in the plan as of January 1st. The offer date, offer date’s just the beginning of the offer period, right? Payroll deductions accumulate and on the June 30th here in this example, you purchase the shares at a discount. You can see the fair market value or the going price of the stock is currently at $20 a share, but you’d be allowed to buy the, you’d be allowed to buy these shares at $17 a share. So, you know, with the 15% discount, $20 per share turns into $17, you’re automatically getting a 15% return. So that’s, that’s a, that’s a nice benefit. It can be a nice benefit for people to kind of add to their compensation, but it does get better even. If we look at the next slide here, we can actually take a look at an example here with what’s called a lookbook. If you, if your ESPP plan has a look back provision, it basically says that you can purchase your company shares at 15% in this case, at a 15% discount, at the lower of the two dates, the offer date or the purchase date. So in this example, again, the stock was trading at $15 a share on the offer date. And again, the purchase price or the purchase date was $20 a share on June 30th. It actually allows you to take it the lower of those two prices, which obviously is $15 per share and lets you take the discount off of that lower price. So, you could potentially get $20 shares at $12.75 after the discount, right? Some people will participate in these almost in the same way that, you know, people like to participate in a company match on their 401(k). That’s the way, you know, a lot of people think about it. They might allocate or accumulate funds, have these purchases and immediately sell the shares if they want, but they and they’re getting taxed at ordinary income tax rates. But, you know, it’s something where they’re, they’re, they feel like they’re picking up a little bit of extra compensation based on participating in the ESPP.
So, as far as tax treatment, this next slide, it’s a little bit complex here, and some of it’s not quite worth getting into, but the best tax treatment is through, again, a qualifying distribution, or excuse me, a qualifying disposition, and, this illustrates, it should look very similar to the, the ISO slide, as far as the, qualifying disposition on ISOs. It’s one year after purchase date or two years after offer date. Both of those components have to be met in order to get the preferential treatment. The key thing to take away from this is that you don’t pay taxes when you purchase, when you have the purchase of the shares, you will pay taxes at the sale of the shares. So the reason why it gets a little complex is that at the, at the sale, you’re going to pay some component of ordinary income and some component of capital gain. And so, the difference between those two and how it shakes out is based on whether or not you have a qualifying disposition or not. If it’s not qualifying disposition, you’re going to pay more essentially in ordinary income tax for that sale, relative to the capital gains tax. So again, if you, if you can, if you have the wherewithal to hang on to this, then it makes sense in terms of where the sale price is. Doing so will actually improve your overall tax payment because you’re paying less in ordinary income tax and a larger portion of the gain in, in capital gains. And I just thought that based on, you know, this and how it works, it was probably getting a little bit more into the weeds here. We can certainly help you with that and help you calculate that if you wanted to speak with a financial advisor here. But, that’s basically how it works. So benefits of the ESPP plan, just wanted to, you know, similar to what I had said before, right? You get to buy the shares at a discounted price, basically automatic gains. It, it uses the automatic payroll deductions, so you don’t really have to think about it, right? You can just make that initial decision and you’re automatically kind of socking away that money and, towards, you know, investing, or purchasing those shares. There is that potential for growth and with a look back provision, it’s typically even better than just the straight discount. So those are some of the keys around that.
Kathryn: I will start by saying if you are a part of the Pure family and you already have a Pure Financial advisor, reach out to your advisor because they know all of these details as well. If you are a guest and not a client of Pure Financial, we welcome you to please contact us for a free financial assessment with one of our experienced professionals like Ian at Pure Financial Advisors. We’ll be able to take a deeper dive into your financial picture because everybody has said, and even if you don’t have these ESOPs or ESPPs or RSUs, all of that, you might have other questions because you have different details. So go ahead and give us a call so that we can set you up and, with a conversation and we can answer your particular personal questions. No obligation, no cost. We are fee only firm. We do not sell anything. We don’t sell any investable products. We do have 4 offices in Southern California and we have offices in Denver, Seattle, Chicago, but we can meet via zoom or in office. So. You know, we can see you wherever you are. You were mentioning strike price and exercise price. Are they the same thing?
Ian: Yeah, they’re effectively the same thing. When it comes to these equity comp plans, a lot of times you’ll more often hear it referred to as the exercise price. Strike price you’ll hear more in terms of marketable securities. So if you have options that are trading on markets, you know, on various companies or indexes, exercise price is use more often, but they are the same thing. It’s what you can purchase- the predetermined price that you can purchase the shares in.
Kathryn: Okay. And then, so both RSUs and options, if I were to sell some of the shares, which would you recommend I sell first?
Ian: Yeah, it’s a great question. So it depends on, you know, your overall tax situation, right? That’s one where we can actually help you with, based on what other kinds of income you have going on. The nice thing about options is you have some flexibility, some control over when you actually take those taxable events in, in like a time based RSU. It really just kind of sequentially, you’re going to get hit with the ordinary income taxes as these shares vest. You don’t really have necessarily any kind of say in when those and in sort of the you know schedule on those. Whereas options you have the ability to again exercise at a specific year depending on where the stock price is and when you sell. You know, you can realize that gain at a future date. You have some flexibility there. It’s really, I think, makes sense for you to sit down with your advisor to see where you are in terms of your tax brackets in any given year and where the stock price is relative to, you know, the exercise price and determine whether or not it makes sense to kind of realize some of those gains in any given year.
Kathryn: Okay. And I have heard of stock appreciation rights are a lot like options. What are the differences between the two? I’m not sure if that gets you much into the weeds, but-
Ian: Yeah, no, it’s, stock appreciation rights are very much like options, in that you have basically a grant price, exercise price at the grant. So there’s a predetermined price. The difference really is that you don’t have to pay for the shares of those- that stock as a part of the exercise. You can basically just say, okay, if the price of the stock is appreciated, I want to exercise and you can actually realize the gain or the bargain element in terms of cash or actually receiving the stock. So if we go back to our example, just thinking about it, if you know, the stock price or the exercise price is $50 a share and the stock is now trading $70 a share. That $20 bargain element. You can take as cash immediately. Just say, hey, this is the difference. I’m going to take the difference and receive that as cash. That’ll be taxed at ordinary income. Or you can say, I want to take $20 worth of shares and that $20 worth of shares establishes the cost basis going forward. You still pay ordinary income taxes either way. But then that if you accepted stock, as a part of that exercise, that will establish the basis there and then determine capital gains tax from there. So it’s a little bit different that you don’t really have to pay for the stock outright through an exercise. You can basically just say, hey, I want the difference and you’ll take that as income.
Kathryn: Great. Can you just explain how to make sure you have a qualifying disposition of an ESPP stock? How can they be sure that they have a qualifying ESPP about the two years, one year? Like how do they make sure?
Ian: Yeah, I think, you know, it’s always, you can always check with the, the plan administration. Like usually it’s a broker dealer that can help walk you through that. You definitely have been, you know, if- when it outlines your, your grants or your awards, it should have very specific a grant date on there. For each award that you receive, or excuse me, the offer date in this case for ESPP, the, the initial date, offer date there. And then, you know, obviously, when the purchase date happened. Again, that’s when it makes sense to keep those confirmations over time. And then you can just kind of determine yourself if you need help. Usually the, the people who administrate these ESPP plans can help you determine that, but it is something you definitely want to focus on. Just, you know, ESPP plans, you, there’s a IRS imposed $25,000 limit on those for participating employees. So it’s not going to typically be a huge portion of your overall portfolio. Some of the differences there might be, you know, in terms of whether or not it’s a qualifying disposition or non-qualifying disposition. Might not, you know, move the needle a ton, but it is good to know and keep track of so that you can, you know, try to minimize your taxes as much as possible.
Kathryn: Okay. We have a few more. I’m not sure. Okay. So, what are some tax strategies for RS-? You kind of already answered this one, but, any other tax smart strategies for RSU stock options and ESPPs?
Ian: Yeah, I think, again, there’s some of the flexibility around options makes it, you know, allows you the ability to, to kind of optimize your taxes, whether or not you participate in ESPP can have an impact. I think, you know, each individual is going to have a different, you know, obviously a different tax impact. So it, you know, I think if you’re, if you’re not clear on sort of the dynamics on that, I think that’s when we can really step in and say, hey, look, you know, your overall income is looking like this. If you were to realize or exercise these options, this is what it could do in terms of your adding to your income, those kinds of things. Again, for RSUs, the time vest or even performance vests, you’re not going to have too much flexibility in there. You’re just going to have to, to realize the, you know, compensation there. But there are some levers and things you can pull to, to make sure that you, you know, optimize your tax situation.
Kathryn: All right. And then what happens to my unvested stocks if my company either gets acquired or goes out of business, or I guess also if they left the company?
Ian: Okay. Yeah, typically, typically any kind of unvested portion will be forfeited, if, if there is an acquisition or merger with another entity, they, those will vary transaction by transaction. Sometimes you’ll receive, shares of the acquiring firm’s stock, which may have tax implications. Sometimes you’ll receive cash as a component of it. You won’t necessarily have too much say in realizing some of that as a taxable event. Whenever you have a situation where you are being acquired or, you know, there’s a merger happening between companies, It’s good to speak with your HR representative to see the, the nature of the transaction and how they plan on compensating. Sometimes they will just accelerate the vesting so that you get all of those given shares and then they’ll convert them to the, you know, the new company stock. There’s, there’s a lot of different ways to handle it, but it’s good to know what they are planning to do so that you can, you know, try to plan around that as far as taxes go.
Kathryn: Gotcha. And then I heard the equity compensation is mainly offered to employees in the tech industry. Does this, do you see it expanding to different sectors? Is it only offered in tech industry?
Ian: I think that’s where you see a, a large part of it. I mean, it’s, it’s, it’s typically offered across all industries really. I think where you see it in equity or the in tech mostly is because some of these tech firms, they don’t have a ton of cash to pay employees. So what they do is offer them equity in the company, right? So they’re, they’re still allowing any kind of excess capital back into the business for the opportunity to grow more. And they still, you know, they’re, they’re still growing. They want to, you know, incentivize employees to either come on board through participating in the equity of the company. There’s a lot of competition, you know, in that space too. So, that’s one of the things that they, you know, use to draw some of these people into these high-tech companies. But again, you’ll have, you’ll have stock plans or equity compensation plans across all industries. And they can vary, you know, based upon a variety of factors, but, it’s not unique to the tech industry for sure.
Kathryn: Okay. What considerations should I take into account when incorporating equity compensation into my overall retirement plan if I’m offered equity?
Ian: Yeah, I think, one of the things we didn’t really touch upon was, you know, I’ve seen many examples where a person will have a lot of their actual wealth tied up in a single stock that they work for, you know, the company that they work for. Sometimes it’s multiple times what’s in their 401(k). Right? So. This can be a pretty big component of their overall net worth. I’ve seen, you know, 30%, 40%, 80% of people’s net worth tied up in a single stock and obviously that kind of concentration that kind of risk is something you want to be aware of and you know, take note of. It can be a double whammy. I can actually, I’m thinking of a colleague of mine, a friend who had worked at Citibank for a number of years, had a lot of her compensation tied into the stock there. And because 2008 happened where most financial institutions had some downturn, she lost her job, unfortunately. And then she also had her shares, you know, plummet, right? So a lot of her net worth was lost along with the unfortunate, you know, instance of her losing a job. So there is concentration risk. Obviously, you want to monitor that. You want to make sure that it makes sense within your overall portfolio. If there’s ways you can diversify around that to reduce your risk, you want to be mindful of taxes, obviously, and look at ways that you might be able to deploy some of that capital in a diversified way. Just kind of recapping here, obviously the potential for gain, you get the ownership stake in the business, your interests really align with, as an employee, align with what the company’s trying to do, right? And, you know, you’re, you’re sort of in lockstep, right? You’re pulling on the same rope in the same direction. Some of the cons, what we have here on the, yeah, so, you know, you’re, you’re having a certain element of your compensation with an uncertain value, right? Cause the, the, the price of the shares could go up or down. You could potentially have, you know, a risk of loss in terms of your, you know, your hard-earned wages or your hard earned compensation could, you know, go down, because of the way, and it might not, you know, be anything to do with your company. It could just be the market environment we’re in, right? So key piece there, could impact you. Market volatility, again, same kind of concept. You know, you might have a home purchase right when markets are down your stock, or it could be the one-off incident that you’ve had within your company that could drive the stock price down right when you’re looking to purchase a home or, you know, put the kids through school, that kind of thing. So, and I think the only other thing it would be is like, you know, again, we talked about some of the tax consequences, and it’s really, it does require some, additional thought and, and planning around how these work, because you want to make sure that you understand how it fits within your overall portfolio. And then again, the tax implications around that. So just the complexity of it. It’s not just, you know, straight earning a W2 paycheck. So, again, we talked a little bit about vesting and any kind of unvested portion. So it is an element of your compensation that you could walk away from or leave on the table. You want to be aware of that and know exactly what that means, if you do a transition.
Again, we talked about the tax implications, the withholding piece. Again, it’s, it’s really a good idea to really understand, you know, how your taxes are being withheld at these vests of these, of these awards so that you can plan around that. You might need to make, you know, quarterly payments or some things like that. There are things that you can do to, to fulfill, your obligation to the IRS, in meaningful ways that, you know, so that you can stay within the rules and not pay any penalties or anything. So you want to understand, you know, how these are, how taxes are withheld on there. And yeah, I guess the last point there, just going back to the concentration risk and having, you know, most of your wealth tied up in a single stock, single asset, you know, it could be, it could have nothing to do with you, could have nothing to do with the direction of the firm. It could be one incident, one rogue employee, right? There could be any, any number of things like that, that could drive a stock price down and could have a meaningful impact to you, if you have the majority of your wealth tied up in that single stock. So.
Kathryn: Well, Ian, this has been extremely informative. And if you’re joining us as a guest and do have more questions and you have those more detailed questions for an advisor, please contact us for a free financial assessment with one of our experienced professionals like Ian. And we can answer your particular personal questions.
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