Many of the high-achieving professionals that we guide have employer stock options. These options can make up a significant portion of the family’s liquid net worth. In addition, they also come with great complexity and confusion when filing your tax return.
I wanted to share with you a few things that I have been sharing with families and give you a few things to consider when thinking about your own stock options.
Restricted Stock Units (RSU’s)
This is the most common type of stock option that we see on a day-to-day basis. Also, they are the easiest to navigate.
Your employer grants you a number of shares as additional form of compensation. When these shares vest they’ll IMMEDIATELY be taxed as ordinary income.
Quick example: You’re granted 500 shares that will vest on September 1st. Come September 1st, the shares are worth $50 per share. Congratulations, you have $25,000 of additional ordinary income!
Vesting taxes are usually withheld at a 22% tax rate (Federal) while State taxes will vary.
Payout: You’ll either receive a reduced amount of shares after taxes are withheld or you may elect to receive cash ($25,000 less your tax withholding).
Note: You have no control over when this taxable event occurs (which is the day of vesting).
Non-Qualified Stock Options (NQ Stock Options)
These are my favorite type of stock options for financial planning purposes. You have 10 years from the date the options are granted until they expire. In addition, there will be a vesting schedule. Generally, you cannot immediately exercise the shares the moment they are granted to you (you must wait for the vesting schedule).
Unlike RSU’s, with NQ Stock Options you can largely control when the taxable event occurs.
For example, you have options that were granted to you in January 2020, and they vest in January 2023. You can exercise your shares anytime between January 2023 (vesting) and January 2030 (expiration).
I love the flexibility that this provides!
When you exercise the stock, you will have ordinary income on the difference between the exercise price and the grant price.
For example, you exercise 1,000 shares with a grant price of $10 per share and a current market price of $15 per share. You will immediately have ordinary income of $50,000 (1,000 shares x $5 gain per share).
Taxes will be withheld.
However, the amount of taxes withheld is generally 22% (Federal) as default (again, State tax rates vary). In most cases, this is not enough and will leave you with a hefty, unexpected tax bill when you file.
We’ve yet to run into anyone who’s pleased with this expensive surprise.
Additional consideration, the downside of NQ Stock Options: They can expire worthless!
For example, you joined a tech company in January 2020. They awarded you 1,000 shares with a grant price of $80 per share that vest in January 2025. Come January 2025, the stock’s worth $10 per share.
This option is worthless (you wouldn’t purchase a stock for $80 that’s only worth $10).
NQ Stock Options provide substantially more flexibility but also carry the risk that the option has no future value. This is a great consideration when negotiating a career change. Would you prefer a higher annual salary or greater (potential) stock option compensation?
Here’s where we come in: Coordinating with a financial planner and your tax professional can help you weigh your options (literally) and approximate a more efficient withholding percentage.
Incentive Stock Options (ISO’s)
While these may not be as popular as the previously discussed options, they carry the most complexity.
Like the NQ Stock Option, you have control over when you exercise the stock option (within the 10-year window from the grant).
If you exercise and sell the underlying stock immediately, things work exactly like the taxation of RSU’s or NQ Stock Options.
However, if you exercise the stock option and decide to HOLD the underlying shares of the stock this does not result in immediate taxation as ordinary income.
The difference between the grant price and the exercise price is called the “bargain element.”
The “bargain element” is not an ordinary taxable event, but could trigger a different tax calculation for your return known as the Alternative Minimum Tax (AMT). This tax is neither alternative nor minimum. The tax is in fact, the opposite. The tax is mandatory and maximum.
While I’m not going to go into further detail in this note about ISO’s, simply due to their unique complexity, I want to simply leave you with the following: Friends don’t let friends exercise ISO’s alone. If you find yourself in an ISO situation, before deciding to exercise and hold, 🙏 PLEASE have a thorough conversation with a financial planner and a tax professional.
The cost of getting this transaction wrong can be severe and have a long-term impact on your financial success.
Unfortunately, we meet new families all the time that have unknowingly triggered the AMT and received a nasty, expensive, surprise when they filed their returns.
While we love welcoming new families as clients, we’d much rather welcome them in a place of thoughtful preparation, than a place to surprise mitigation.
If you or someone you’re close to is a high-achieving professional that could use help aligning their finances and establishing a financial plan, please reach out to us, we’re accepting new clients and eager to help.
Cheers, Nic
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
