Equity compensation is a great way for people to build wealth.
I mean who would not want the ability to buy stock at a discounted price?
Or to have extra stock given to them for bonuses?
Both create the ability to accelerate your wealth building journey when you plan well.
In today's world, equity compensation is more and more common. But with stock options and RSUs comes a lot of complex financial and tax planning considerations.
This is typically not something you want to handle alone.
In this post, I am going to walk you through some of the biggest mistakes we see people make as it relates to their equity comp:
With Incentive Stock Options (ISO), you get favorable tax treatment. Let me show you what I mean by that.
Let’s say you were granted 10,000 stock options vesting over 4 years with a 1 year cliff at a price of $1 a share. This means at your 1 year mark 2,500 shares become yours and you could exercise them for the price of $1. If you exercised all, you would pay $2,500.
Then you would owe $0 in tax unless you trigger AMT. AMT is an alternative at 26 or 28%. This is where tax planning becomes really important. You need to nail down how much room you have free without triggering AMT. Let’s say you have $20,000 of Spread before you trigger AMT.
Spread refers to the difference between the exercise price and the market price. In this example, let’s say the market price is $5. If you exercised all, your spread would be $4 ($5-$1) x 2,500 shares = $10,000. Since you have $20,000 of room, you would owe no AMT.
The issue here is that many wait a very long time to exercise and this spread gets very large and so does their AMT Bill.
Let’s say you wait 5 years, all shares have vested, and the market price is $100. To exercise all, it would cost $10,000, but the spread is now $99. This means if you exercised all 10,000 x $99 that would be $990,000. If you only had $20,000 of room but exercised this much, you would owe AMT on $970,000. This would create a massive tax bill that is hard for anyone to manage.
You really need to think about risk, AMT, taxes, etc. to come up with a plan. Hiring a professional is the best way to navigate this.
I know this is the exact opposite of what I talked about above, but let me explain. Exercising options on private companies is very risky since the company may never have an event that allows you to cash in on these options. This means you could exercise all your shares, the company fails, you lose all that money you spend on buying the options.
Exercising early is about minimizing tax.
Exercising late is about certainty.
You really need to think through this well and balance the two.
AMT can really suck (shown in the example above), but it is not all bad news. You do get a tax credit that can be used later when you sell the shares and can be used in some years where you don’t trigger AMT.
I have seen many times people forget about this and not utilize the credit on future years returns. Make sure to stay on top of this if you are doing your own taxes (which you shouldn’t) or if changing tax preparers/
83(b) elections allow you to choose to pre-pay the tax early on when the shares have very little growth. This is something that can be used for ISOs (with early exercise), Restricted stock, and potential in private equity with carry.
Oftentimes, people do not know about this early enough and do not take advantage of it. This is a huge mistake as it helps minimize tax and start the long term capital gains clock earlier. But know, you only have 31 days from the time the options or restricted stock are granted to do this. Missing it can mean a huge difference in taxes.
Your ISOs will turn to NSOs 90 days after you leave your job and you typically have 3 years from then to exercise. Time and time again, people either forget about their options and let them expire worthless. Or they forget about the ISOs turning to NSOs and losing the favorable tax treatment. It is your job to stay on top of this and know the timelines to maximize the options given.
Unless you have over $1,000,000 of RSUs vesting per year, RSUs are typically withheld at 22%. This is a huge problem for all my high income earners out there. You may be in the 37% bracket but only selling shares to cover 22%. I have clients getting $500,000-$800,000 in RSUs a year, this means they would underwithhold by $75,000 to $120,000. This is a huge issue for a couple reasons.
First being you will have underpayment penalties most likely. And second being you may be scrambling to find this cash come tax time because you did not plan well. This is why intra year tax projections are so important.
RSUs come through on your w2 as you pay income tax at the time of vest. Oftentimes, this and your brokerage where the RSUs are held do not speak to each other. This means people will end up having a $0 cost basis shown on their investment statements and end up paying way more tax since their cost basis is the price at time of vest.
This is something you want to stay on top of so you do not pay double tax.
I get it, you work for the company, you have passion for it, and you want exposure to the company stock. There is nothing wrong with that, but you do not want to become too concentrated in your company stock.
Your income, your net worth, etc. are all reliant on one company and that can be risky. And on top of that, if you have more equity vesting in the future, you already have exposure to your company’s future growth. It often makes sense to sell at least some of your company stock and diversify your investments into other areas.
I sometimes see people choose to not sell any shares of RSUs to cover taxes, or underwithhold at 22%, this means you are effectively choosing to buy even more company stock since you are not selling to cover the actual tax liability. Be careful here!
At the end of the day, equity compensation is a great wealth building tool, you just have to manage it well.
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Financial Advisor