April is National Financial Literacy Month. For most employees, few financial endeavors are more complex than understanding stock options, restricted stock, restricted stock units (RSUs), employee stock purchase plans (ESPPs), and other forms of stock compensation.
As tax season is over, now is a good time to direct your attention to improving your financial fluency and money-management habits for equity awards and ESPP participation. These valuable yet tricky forms of compensation can make a big difference in achieving both short-term and long-term life goals, such as boosting cash flow, funding college, buying a house, or saving for retirement.
Below are seven ways you can sharpen your acumen with your stock compensation. Before you start, be sure you gather and review all of your stock-plan-related documents, including the grant agreement, the grant notice, the stock plan itself, and any company communications about these.
1. Set Goals
All financial planning starts with setting goals. What do you want to do with the proceeds from the eventual sale of shares acquired from stock options, restricted stock/RSUs, or an ESPP?
Having a purpose motivates you to improve your financial literacy. A clear understanding of how stock comp fits into your life will strengthen your incentive to understand all the complicated details.
Coming up with concrete goals will also help to clarify your use of the shares in relation to your salary, cash bonus, and 401(k) holdings and other savings.
2. Know What Type Of Equity Award(s) You Have
Many financial advisors I’ve spoken with have clients who initially tell them they have stock options when it turns out they have restricted stock units—which work very differently. While in popular parlance stock options has become a generic term for all types of equity compensation, you need to know the difference between actual stock options and other grant types.
Employee stock options give you the right to purchase a specified number of shares of the company’s stock at a fixed price during a rigidly defined timeframe.
Alert: Know your company’s procedures for accepting grants and exercising options. Exercise often involves a third-party website, such as that of the broker it designates.
Companies can grant two types of options: nonqualified stock options (NQSOs), the more common variety, and incentive stock options (ISOs). Before exploring the differences between NQSOs and ISOs, you must check your grant notice to know which type of options you have. ISOs have tax advantages and complexities, as explained in #3 below.
Restricted stock and restricted stock units (RSUs) are grants of company stock that you get outright once they vest. Usually, you don’t pay anything for shares granted by a public company.
Restricted stock and RSUs differ in a few ways. Restricted stock is issued at the time of grant and is held in escrow. You can’t sell or otherwise transfer the stock until vesting occurs. By contrast, RSUs are technically an unfunded promise to issue you shares when the vesting period has been satisfied. The shares are then “delivered” to you. RSUs are simpler for companies to administer, and in public companies RSU grants are much more common than grants of restricted stock.
3. Understand The Core Tax Treatment
With nonqualified stock options, at the time of option exercise you pay withholding taxes (federal income tax, any state income tax, Social Security up to the yearly maximum, Medicare). After that, any gains above stock price at exercise (i.e. your cost basis) follow the capital gains tax rules.
Incentive stock options qualify for special tax treatment under the Internal Revenue Code. You do not have any Social Security or Medicare tax and no income tax withholding, even if you sell the shares immediately.
Should you decide to hold ISO shares for more than two years from the date of grant and one year from the date of exercise, all appreciation over the exercise price is taxed at the lower long-term capital gains rates (i.e. none of the gain is taxed at ordinary income rates). However, the exercise spread on shares acquired from ISOs and held beyond the calendar year of exercise can subject you to the alternative minimum tax (AMT) and additional tax-return reporting.
Alert: You should consult a qualified financial or tax advisor do an AMT calculation whenever you hold the ISOs shares at exercise. Do it again at calendar year-end to decide whether to sell the shares to avoid the AMT.
With restricted stock/RSUs, you pay taxes through withholding on the income recognized at vesting (federal income tax, any state income tax, Social Security up to the yearly maximum, Medicare). When you sell the shares, any gain or loss above the compensation income you recognized (i.e. your cost basis) is taxed under the capital gains rules.
Alert: Compare the withholding rates your company uses for your stock compensation income to your marginal tax rate. If the withholding rate is lower and thus won’t cover all the taxes you owe, consider putting money aside to pay the taxes with your tax return or the need to pay estimated taxes.
4. Identify The Vesting Schedule Of Stock Options, Restricted Stock, And RSUs
The vesting schedule of your grant dictates when you may exercise stock options, when forfeiture restrictions lapse on restricted stock, or when shares are delivered with RSUs.
Alert: Each grant you receive has its own vesting schedule and other terms.
Vesting is usually based on continuing to provide services for the company over a specified period. A grant can be designed to vest all at once (e.g. after four years) or in pieces, called tranches (e.g. 20% of the grant every year for five years, or 25% of the grant the first year and monthly after that). Especially for executives, the vesting schedule can also or instead be performance-based (e.g. tied to company-specific or stock-market targets, such as total shareholder return).
Once stock options have vested, you can exercise them—but you don’t have forever to do so. Stock options have a fixed term, usually ten years. At the end of the option term, any unexercised stock options expire and you have no way to get them back. Therefore, if your options have a ten-year term and are fully vested after four years, you will have six years during which to exercise them, assuming you keep working for the company (you will have less time to exercise options after job termination, as explained in #6 below).
5. Learn How Your ESPP Works
Employee stock purchase plans (ESPPs) are a type of stock-related company benefit in which your company deducts money from your paycheck to buy shares of its stock, often at a discount. ESPPs have their own key dates and rules to know, especially regarding enrollment to participate in the plan and how to change your contributions. During an ESPP purchase period, payroll deductions are accumulated. Shares are typically bought on the purchase date at the end of the period.
Alert: If your company has an ESPP, it can be a great deal. It’s vital that you know how and when to enroll and to later make any changes you may want.
There are two types of ESPPs: tax-qualified and nonqualified.
Tax-qualified ESPPs (also called Section 423 ESPPs for the tax-code section that sets the rules) let you buy shares at a specified discount of up to 15% from the stock price. Some companies use a lookback provision that bases the discount calculation on the stock price at either the start of the offering or end of the purchase period, whichever is lower. The IRS lets you buy up to $25,000 in shares during any calendar year, based on the price at the start of the offering, though your company may impose a lower limit.
You have no Social Security or Medicare tax and no income tax withholding at all. The sale (not the purchase) triggers taxes. If you hold the shares long enough to meet the holding periods (more than one year from purchase and two years from enrollment) for favorable tax treatment, most of your gain is taxed as long-term capital gain when you sell the shares.
Nonqualified ESPPs work in the same way but without the IRS rules and favorable tax treatment of qualified plans. A discounted price or contribution match (if any) produces ordinary income at purchase.
6. Study What Will Happen If You Lose Your Job
Read your stock plan documents and your grant agreement carefully to know your rights if you are fired or if you quit, work for a competitor, retire, become disabled, or die. Make sure you, as well as your family or close friends, are aware of these rights.
With stock options, many plans give you no more than 90 days to exercise vested options after job termination, though the post-termination exercise period can be longer for certain life situations. However, you may lose vested options immediately if you leave the company to work for a direct competitor.
With restricted stock and RSUs, job termination almost always stops vesting and causes the forfeiture of unvested grants—you lose shares that have not yet vested. You keep any shares that vested before your termination date.
Exceptions can occur to accelerate vesting or let it continue, depending on the terms of your grant agreement or stock plan, such as special provisions for disability or death, for retirement, or for a change in corporate control (e.g. a merger or acquisition), or in a broad layoff.
Alert: If you are planning to leave your job soon, you may want to stick around long enough to get any valuable equity grants that may vest in the near future.
For more details on this topic, see my Forbes.com article Protect Your Stock Options And RSUs In Job Loss: 3 Key Actions.
7. Keep A Stock Comp Checklist
One good way to start with your stock compensation is to be sure you know the answers to the questions in a checklist you prepare. Questions on it may include:
1. What is the vesting period of stock options or restricted stock/RSUs?
2. How do I enroll in my company’s ESPP and make any changes in contribution amounts?
3. With stock options, how long do I have before the grant expires?
4. What would happen to my grant if I were to leave or lose my job, die, become disabled, or retire? How do these events affect vesting and the forfeiture of the grant?
5. What are my goals for the income that I will receive from my stock compensation and/or ESPP? Do I want to use the gains for near-term goals (e.g. college tuition, downpayment for a house purchase) or for long-term goals (e.g. retirement)?
When you’re ready for more, the educational resources at myStockOptions.com can help you with all aspects of stock compensation and ESPPs, from the basics to tax reporting and financial-planning strategies. The website’s resources include calculators and modeling tools, videos, and interactive quizzes to test your financial fluency with stock options, restricted stock/RSUs, and ESPPs. If you want personal guidance, seek the counsel of a qualified financial or tax advisor.