Planning for Retirement with Stock Options and RSUs: A Comprehensive Guide

Planning for Retirement with Stock Options and RSUs

Planning for Retirement with Stock Options and RSUs can be complex and overwhelming. Retirement planning is a crucial aspect of your financial independence. And for individuals fortunate enough to have stock options and Restricted Stock Units (RSUs) as part of their compensation package, these assets can play a significant role in securing a comfortable retirement. This article will delve into stock options and RSUs, discussing Incentive Stock Options (ISOs), Non-Qualified Stock Options (NQSOs), RSUs, and Restricted Stock. We’ll explore how these assets can be integrated into your retirement plan while considering various tax implications, concentrated risk, and the importance of a comprehensive financial view.

Understanding Stock Options and RSUs

Incentive Stock Options (ISOs)

Incentive Stock Options, or ISOs, are a type of stock option usually granted to employees as an incentive. They come with tax advantages but also have specific requirements. ISOs allow employees to purchase company stock at a predetermined price, known as the exercise or strike price. To qualify for favorable tax treatment, ISOs must be held for at least two years from the date of grant and one year from the date of exercise. Gains from ISOs are typically taxed at the more favorable long-term capital gains rate.

  • Favorable tax treatment
  • Long-term capital gain tax is 15% or 20% versus your tax bracket
  • Maximum $100,000 of underlying stock value per year
  • No federal and state income tax at the time of exercise
  • If held at least two years from the grant date and one year from the exercise date, you will pay long-term capital gains
  • You may owe Alternative Minimum Tax (AMT) on your bargain element
  • AMT is due every quarter
  • ISOs must expire after ten years
  • ISOs are not transferrable.
  • Disqualifying disposition if you sell shares before the 2-year / 1-year period.
  • Eligible for 83b election

Non-Qualified Stock Options (NSOs)

Non-Qualified Stock Options, or NSOs, are another type of employee stock options.  NOSs are more flexible but have less favorable tax treatment than ISOs. Employees can purchase company stock at the exercise price. NSOs are generally taxable as ordinary income at the time of exercise.

  • Less favorable tax treatment
  • The exercise of NSO is a taxable event.
  • All Federal, payroll, and state income taxes are due on the difference between the Fair Market Value (FMV) of your options and exercise cost
  • FMV at exercise will be the cost basis of your shares
  • Long-term capital gains or losses if you hold your shares for more than one year
  • Short-term capital gains or losses if you hold your shares for less than one year
  • Early exercise when you sell your shares immediately after exercise
  • Eligible for 83b election

Restricted Stock Units (RSUs)

RSUs are a form of equity compensation where employees receive a specified number of company shares at a predetermined future date, usually contingent on meeting certain conditions like time-based vesting or performance goals. When RSUs vest, the value of the shares is typically reported as ordinary income and subject to taxation.

  • RSUs are equity grants with a 4-year vesting schedule
  • The entire value of your vested shares is taxable as ordinary income
  • Taxes are withheld at the time of vesting.
  • The default 22% Federal and 10.23% California withholdings
  • Public companies usually sell a portion of your vested shares to cover taxes.
  • You may need to sell additional shares to pay your full tax amount.
  • Long-term capital gains or losses if you hold your shares for more than one year
  • Short-term capital gains or losses if you hold your shares for less than one year
  • Some startups have a dual trigger vesting schedule. Taxes are due at the time of IPO or exit.
  • Not eligible for 83b election

Restricted Stock Awards

Restricted Stock Awards (RSAs) are similar to RSUs, but employees receive actual company shares at the time of grant, which are typically subject to certain restrictions. These restrictions often involve a vesting period or performance targets. When these restrictions are lifted, the value of the shares is usually subject to taxation.

  • RSAs are typically issued to early-stage employees and founders when FMV is very low.
  • Employees pay for their RSAs at a pre-determined price.
  • The difference between the current FMV and the original purchase price is taxable as ordinary income.
  • Long-term capital gains or losses if you hold your shares for more than one year
  • Short-term capital gains or losses if you hold your shares for less than one year
  • Eligible for 83b election

Employee Stock Purchase Plan

An Employee Stock Purchase Plan (ESPP) is a company-sponsored program that allows eligible employees to purchase shares of their employer’s stock at a discounted price. ESPPs are a popular form of employee benefits. They are designed to enable employees to become partial owners of their company while offering potential financial benefits.

  • $25,000 annual limit
  • You purchase the shares at a 15% discount from the market price
  • Lookback feature allows you to buy shares at a lower price between the beginning and end of the period.
  • Shares are not taxable until you sell them
  • You must hold the shares for two years after offering and one year after purchase
  • The discount is taxable as ordinary income
  • You pay long-term capital gains on the difference between the sale and market prices on the acquisition date.

Incorporating Stock Options and RSUs into Retirement Planning

 Understand what you own

First and foremost, before starting to plan for retirement, you must fully understand what type of equity compensation you have.  There are many rules and restrictions concerning stock options and RSUs. Make sure that you follow the rules and use them to your advantage to maximize your financial outcome.

Know your goals

Knowing your financial goals is a critical foundation for effective financial planning. Your goals will serve as your roadmap, guiding your financial decisions and helping you prioritize where you allocate your resources. Whether saving for retirement, buying a new home, funding your children’s education, or making charitable contributions, having clear, well-defined financial objectives allows you to set specific targets and create a strategic plan to reach them. Understanding your financial goals provides motivation, focus, and a sense of purpose in managing your money, ultimately paving the way to financial security and realizing your dreams.

Assess Your Comprehensive Financial Picture

Retirement planning isn’t just about stock options and RSUs. It’s essential to assess your entire financial situation. This includes other assets, liabilities, savings, and expenses. Creating a comprehensive financial plan that integrates all aspects of your financial life, including your stock-based compensation, can help you decide when and how to retire.

Diversification to Manage Concentrated Risk

Stock options and RSUs can lead to concentrated holdings in your employer’s stock. While it’s a sign of confidence in your company, it can also expose your retirement savings to significant risk if your company faces financial difficulties. Diversification is key. As you approach retirement, consider gradually reducing your exposure to your employer’s stock and reallocating your investments into a diversified portfolio to mitigate risk.

Tax Planning

Effective tax planning is crucial when dealing with stock options and RSUs. Depending on the type of assets you hold, you should exercise them or sell them strategically to optimize tax consequences. This often involves balancing the timing of exercising options and selling shares with your overall financial situation and tax bracket.

Seek Professional Guidance

Stock options and RSUs can be valuable assets in your retirement planning strategy. By understanding the different types of stock-based compensation and considering factors like taxation, diversification, and your comprehensive financial situation, you can maximize the benefits of these assets while ensuring a secure retirement. Remember that careful planning, professional guidance, and a long-term perspective are the keys to successfully incorporating stock options and RSUs into your retirement plan.

Given the complexity of stock options, RSUs, and tax implications, it’s often wise to consult with a financial advisor or a tax professional who specializes in equity compensation planning. We can help you navigate the intricacies and make well-informed choices that align with your retirement goals.

Babylon Wealth Management excels in helping employees with stock-based compensation plans for a secure retirement. Our team of experienced financial advisors understands the complexities of stock options, RSUs, ESPPs, and other equity-based incentives. We work closely with clients to develop tailored retirement strategies that maximize the potential benefits of these assets while also mitigating risks. From tax-efficient exercise and sale strategies to diversification techniques and comprehensive financial planning, our experts provide guidance every step of the way. With Babylon Wealth Management, you can confidently navigate the intricacies of stock-based compensation to build a retirement plan that aligns with your financial goals, ensuring a prosperous and worry-free retirement future.

Tax planning when exercising your stock options and selling your company stock

Tax planning when exercising your stock options

Tax planning when exercising your stock options is essential to manage your tax risk, maximize your gains and avoid any unpleasant surprises with the IRS. If you are sitting on a pile of ISOs and NSOs, now is the time to consider exercising some of these grants.

The tax impact of exercising your stock options can be complex. There are many moving parts, and everyone’s circumstances are different. I am sharing some ideas with you on how to plan for exercising your stock options. Whether you aim to exercise at year-end or throughout the year, there is no one-size-fits-all strategy.

Feel free to make an appointment if you have any questions.

Exercise your ISOs up to the AMT breakeven limit.

Exercising ISOs are not subject to Federal and state income taxes, but you may pay Alternative Minimum Tax. The AMT is a parallel tax system that adds certain income, such as the ISO bargain element and the interest from certain types of Municipal bonds, to your regular income. Furthermore, the AMT system uses two tax brackets – 26% and 28%, respectively- with its own standard deductions. The AMT typically impacts just 0.1 percent of US households overall.

Most people receive an AMT exemption every year. The annual exemption is the difference between what you owe on your regular tax income and the AMT calculation. You may know it as AMT breakeven.

You can exercise enough ISOs annually to keep you under the AMT breakeven level. However, this annual AMT breakeven benefit is “use it or lose it.” You cannot roll it over for next year.

Suppose the FMV of your ISO is higher than your exercise price. This strategy could help you stay within a reasonable budget and start the one-year holding period on shares for favorable long-term capital gains tax treatment.

Exercise ISOs during high-income years.

The AMT breakeven point will likely be much higher if you have a significant windfall year. Let’s say you received a large bonus, sold your startup, or hit the jackpot. You will most likely be able to exercise a higher number of ISOs before you reach the AMT exemption.

Exercise NSOs to fill in your tax bracket.

Unlike ISOs, non-qualified stock options (NSOs) are subject to Federal, payroll, and state income taxes. Exercising a big chunk of non-qualified stock options can easily throw you in a higher tax bracket. In high-income tax states like California, your total payable tax can exceed 50%. You will end up keeping only half of your gains.

Depending on your tax situation, you can consider exercising just enough NSOs to keep you within your desirable tax bracket.

Use AMT credit by exercising NSOs or receiving RSUs

Once you pay AMT, you receive a tax credit, which will be payable to you in future tax years. Most people recoup their AMT taxes, but the exact timing depends on your specific circumstances.

You may have the entire suite of grants ISOs, NSOs, and RSU through your current employer or previous startups. If you have exercised ISOs in the past, you may have an outstanding AMT credit.

In that scenario, your AMT credits can offset the taxes you must pay for exercising NSOs or receiving RSU grants.

Exercise ISOs and NSOs with a low bargain element.

If you have recently received ISO and NSO grants, there is a good chance that the fair market value of your unexercised grants will be equal to or closer to the original exercise price. By exercising these specific lots with a small spread between FMV and exercise price, you may have a low to no bargain element. In that scenario, you may not owe any taxes. The downside of this strategy is that for more mature startups with appreciated FMV, exercising newer grants may require a higher cash expense.

Spread an exercise window across two tax years.

If your exercise window stretches between two calendar years, you can decide how much to exercise each year. Again, depending on your specific tax situation in the current and the following year, you can exercise a portion of ISOs and NSOs in December and then another lot in January.

83b election

83b election allows startup employees to exercise their stock options and other equity grants early and pay income taxes based on the Fair Market Value at the time of the election. You must file a one-page form to the IRS declaring your early exercise decision. The election entails that you exercise your ISOs and NSOs before they start vesting. Your primary benefit would be to avoid paying taxes on the growing spread between fair market value and exercise. If your exercise cost and FMV match at the time of your 83b election, you will avoid paying AMT on ISOs and income taxes on your NSOs. The downside is that you will be fully invested in your startup and need to put in upfront capital.

Prioritize long-term capital over short-term capital gains

Long-term capital gains receive favorable tax treatment. They are subject to a 15% or 20% tax rate. On the other hand, short-term capital gains trigger ordinary income tax, which is generally higher. You could pay over 50% in taxes in high-income states like California.

All else equal, prioritizing long-term capital gains can significantly impact your final outcome.

The moment when you exercise your NSOs and ISOs or receive your RSUs, and ESPP shares sets the clock on your holding period.

Each grant has different rules that make them eligible for long-term capital gains.

  • ISOs – 1 year from the exercise date and two years from the grant date
  • NSOs – 1 year from the exercise date
  • RSUs – 1 year from the vesting date
  • ESPP shares – 1 year from the purchase date and two years from the grant (offering) date

Tax-loss harvesting

Tax-loss harvesting is a strategy that aims to realize a loss on a position in your investment portfolio. You can use the proceeds to invest in similar security. However, when it comes time to pay your taxes, you can offset any gains from selling your company shares with realized losses from your tax-loss harvesting strategy. In addition, if your losses are bigger than your gains, you can use the remaining amount to offset up to $3,000 of your ordinary taxable income.

Let’s take an example:

You own 1,000 shares of company XYZ, which you acquired for $100 per share. The total cost basis is $100,000.

In addition to that, you own 10,000 shares from your employer ABC. The cost basis per share is $5

One year later, the price of XYZ dropped from $100 to $75, while the price of your employer shares is $20. You want to sell 2,000 of your company shares, but you want to avoid paying hefty taxes. If you sell your shares, your capital gain will be $30,000. You noticed that your XYX shares have dropped, and if you sell them, you will realize a loss of $25,000. Instead of paying capital gain taxes on $30k, you will only pay taxes on a 5k gain.

ABC capital gain

2,000 shares x ($20 – $5) = $30,000

XYZ capital loss

1,000 shares x ($75 – $100) = -$25,000

Total gain = $30,000 – 25,000 = $5,000

Don’t ignore the tax man

April 15 is the conventional deadline for tax filing. However, the IRS expects you to pay at least 90 percent of your estimated tax liability upfront. If you exercise your shares throughout the year are responsible for paying your taxes, including your AMT. There are four quarterly deadlines for making estimated payments in four equal amounts.

  • 1st payment …………….. April 15
  • 2nd payment ……………. June 15
  • 3rd payment …………….. September 15
  • 4th payment …………….. January 15

You might be subject to penalties if you owe a sizable amount and wait to pay it during the tax season.

Have a comprehensive plan.

The tax implications of exercising stock options can be complex. And there is little room for error. Through my years of experience helping my clients, I can share that the best strategy for you is to have a comprehensive plan. Before exercising your ISOs and NSOs, you must have a holistic view. There are many moving parts with any strategy. The most challenging part is predicting the future fair market value or exit price. Some of our clients have multiple grants from different companies,  various sources of income, or a high-earning spouse. Any additional layer of complexity can dramatically change your assumptions.

Choosing between RSUs and stock options in your job offer

RSUs and stock options

RSUs and stock options are the most popular equity compensation forms by both early-stage start-ups and established companies. If you receive equity compensation from your employer, there is a good chance that you own a combination of different equity grants. RSUs and stock options have some similarities as wells as many differences in tax treatment and potential upside. Sometimes your new employer may offer you the opportunity to choose between having RSUs or stock options. Or you already own a mix of them. The purpose of this article is to describe how each compensation works. You will learn how they affect your taxes and how to plan for future upside.

What are RSUs?

RSUs (Restricted Stock Units) are a type of equity compensation in the form of company stock. Typically, your employer will grant you a specific number of shares that will vest over a particular period. The classic vesting schedule is four years with a first-anniversary cliff equal to 25%.  The remaining shares will vest gradually on either a monthly, quarterly, or annual basis.

Taxes on RSUs

RSUs are taxable as ordinary income. Every time your RSUs vest, the fair market value of your shares will be added to your W2 earnings. The employer must withhold Federal and State income tax. In most cases, public companies will sell a portion of your shares to cover all taxes. In the end, you will own a smaller number of shares than your original grant.

Example. You have 1,000 RSUs of company XYZ, which get vested tomorrow.  The fair market value is $10. Therefore $10,000  [1,000 x 10) will be added to your payroll. To cover all Federal income, FICA, and state taxes, the company will sell 300 shares from the total. The proceeds of $3,000 will be used to cover your tax obligations. You can keep 700 shares which you can either sell immediately or keep long term.

If you hold and sell your RSUs before the 1st anniversary of their vesting, all potential gains will be taxable as short-term capital gains.

If you hold and sell your RSUs for longer than one year after vesting, all potential gain will be taxable as long-term capital gains

Double Trigger RSUs

Many private Pre-IPO companies would offer double-trigger RSUs. These types of RSUs are taxable under two conditions:

  1. Your RSUs are vested
  2. You experience a liquidity event such as an IPO, tender offer, or acquisition.

You will not owe taxes on any double-trigger RSUs at your vesting date. However, you will pay taxes on ALL your vested shares on the day of your liquidity event.

What are stock options?

Employee stock options are another type of equity compensation that gives you the right but not obligation to purchase a specific number of company’s shares at a pre-determined price.

Incentive stock options (ISOs)

ISOs are a type of employee stock option with preferential tax treatment. They can only be granted to current employees. You can receive up to $100,000 of ISOs every year. If your total grant exceeds $100,000, you will receive the difference as Non-qualified stock options (NSOs). Most ISOs and NSOs grants will have a 4-year vesting schedule with a one-year cliff. For more information about ISOs, check out this article.

Taxes on ISOs

The vesting and exercise of ISOs do not trigger income taxes.

If you hold your ISOs for two years from the grant date and one year from the exercise date, you will owe long-term capital gains of the difference between the sale and exercise price.

AMT

The exercise of ISOs may cause paying Alternative Minimum Tax (AMT). The AMT is an alternative tax system that is calculated in parallel with your regular taxes. The bargain element or economic benefit of your exercise equals the difference between the Fair Market Value (FMV) and the exercise price of your shares. The AMT formula adds the bargain element to your regular income and calculates a minimum tax rate. If the AMT value is higher than your regular income, you will have to pay the difference to the IRS.

The probability of paying AMT increases as the gap between your shares’ Fair Market Value (FMV) and exercise price widens.

It is crucial to remember that the AMT is a future tax credit. You can potentially recoup all of it. Every year when your AMT dues are lower than your regular taxes, you will receive a tax rebate until you deplete the entire credit.

Non-qualified stock options (NSOs)

NSOs are another type of employee stock option. However, they lack the preferential tax treatment of ISOs. Furthermore, NSOs can be granted to a broader group of stakeholders. For more information about NSOs check out this article.

Taxes on NSOs

The exercise of ISOs triggers Federal and state income taxes. The difference between your shares’ Fair Market Value (FMV) and the exercise cost is taxable as compensation income. Whether your employer is a public company or a startup, you will be responsible for paying the taxes due from the option exercise.

How to choose between RSUs and stock options in your job offer

There is a rule of thumb that 1 RSU is equal to 3 or 4 stock options. Most companies that give you a choice between RSUs and stock options will likely offer you a similar ratio. Let’s discuss some of the key factors that can help you choose between the different grant types.

Public versus private company

Private companies and startups tend to gravitate towards offering ISOs and double-trigger RSUs. These two equity compensation types require the lowest financial commitment from the employees before any liquidity event or an IPO.

Public companies tend to offer traditional RSUs and employee stock purchase plans (ESPPs). You can read more about ESPPs here. Many recent public companies will maintain legacy stock options from their startup stage but will not issue new grants.

Early-stage vs. established startups

Early-stage startups with fewer employees usually give generous ISO grants at below a dollar per shares valuations. The shares are often worth a few cents. These grants offer the biggest upside if the venture becomes successful down the road. Exercising your shares early will allow you to avoid or minimize AMT and pay long-term capital gains when selling your shares in the future. The biggest downside of an early startup is that your first liquidity event might be years away. You may not see a windfall for a long time.

More mature or pre-IPO startups might offer a wider range of equity compensation types. If you join those companies, you may end up owning a mix of ISOs, NSOs, and RSUs. Working for a more established startup, you will be closer to a liquidity event. But the cost of your stock options will be a lot higher. You may have a chance to sell your share through a tender offer or a pending IPO.

Sometimes your company may get acquired by a larger firm. When that happens, your stock options and RSUs will be converted to the acquiring company’s stock.

Liquidity and cash

Owning RSUs generally requires spending less upfront cash. Your company will pay your taxes by selling a portion of your shares on the open market. You don’t have to dip in your checking account.

Both ISOs and NSOs require paying your exercise cost out of pocket. You also may owe taxes or AMT on the transaction.

Cashless exercise

In some cases, employers offer a cashless exercise either through a tender offer or post-IPO.  If you are opt-in for a cashless exercise of your ISOs, they will lose their preferential tax treatment and automatically turn into NSOs.

With a cashless exercise, you exercise your shares and immediately sell them to the buyer. If your firm is private, the buyer can be the company itself or an external investor. If your company is public, you will sell your shares on the stock market.

The exercise cost of your shares will be subtracted from the total value of the proceeds after the sale. Sometimes your payroll department will withhold taxes automatically. Otherwise, you will be responsible for paying taxes on your gains.

The upside potential of RSUs and stock options

From a risk-reward perspective, traditional RSUs offer a lower risk relative to stock options. You can get more predictable payouts if you choose to receive RSUs or NSOs from a public company.

In contrast, owning stock options of an early-stage startup offer a higher risk/reward upside potential. At the same time, your financial outcome is a lot more uncertain. Your windfall will depend on your company’s success in addition to your strategy to exercise your shares early, well in advance of any liquidity events.

Waiting to exercise your ISOs after receiving a tender offer or going public can create issues with paying extremely high AMT and reducing your financial upside by paying higher taxes.

Final words

In closing, the benefits of owning RSUs and stock options will depend on the odds of your company running a successful business model, getting acquired, or going public. There is a massive range of financial outcomes depending on when you exercise your shares, your investment horizon, risk tolerance, cash savings, tax situation, and a little bit of luck. If you want to get the most out of your ISOs, NSOs and RSUs, you need to plan proactively. The decisions that you take today will impact what you keep in your pocket years down the road.

Step by Step Guide to Planning for Early Stock Option Exercise

Early Stock Option Exercise

Planning for Early Stock Option Exercise can be overwhelming and challenging. if you are one of the many employees of early-stage startups and private companies who receive equity compensation in the form of stock options and RSUs., this article will give you a starting point.

Planning for Early Stock Option Exercise

You probably want to understand how owning stock options will impact your long-term wealth.  The exact specifics of your equity compensation will vary widely from one company to another. There is also a vast range of possible outcomes regarding the value of your equity and the timing of your liquidity event. Your tax implications depend on when and how you exercise your stock options and how long you hold your vested stocks. Furthermore, many employees will struggle with the high concentration of your net worth in a single company.  Burdened with many questions and a few answers, tech workers often delay early stock option exercise until closer to an IPO or other liquidity event.

So, what do you do next? Here are some ideas that can help you navigate the complex world of equity compensation and early stock option exercise.

1. Know what you own

The best way to master your equity ownership is to take a step back and figure what you own. Reach out to your payroll department or stock option vendor and ask for more information about your stock option holdings.

In general, there are two types of employee stock options – Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). You will most likely own one or the other or some combination of the two. While they may look very similar on the surface, there are significant financial and tax differences between ISOs and NSOs.

ISOs, generally, offer a more favorable tax treatment. There are no taxes due upon your ISO’s exercise, but that can force you to pay an Alternative Minimum Tax.

In comparison, NSOs offer slightly little more flexibility but trigger an immediate taxable income at exercise. Both employers and other stakeholders can receive NSOs.

2. Keep track of key dates and figures

Keeping track of important dates and figures is the next step in mastering your stock options. In most cases, you must start from the moment you receive your job offer. In my article “Guide to understanding your job offer with stock options,” I discuss evaluating a job offer that includes a combination of salary and stock options. There are a handful of important dates and figures that you need to keep track of. Here is the alphabet of terms you have to remember – a number of shares, vesting dates, exercise dates, strike price, fair market value, and vested versus unvested shares.

Furthermore, as you continue working for the same firm, you may receive other stock option grants with different strike prices.  Create a spreadsheet or use the information provided by your option vendor to track all the numbers. It could be cumbersome, but it can help immensely when making early stock options exercise decisions.

3. 83b election

Some companies may allow you for IRC § 83(b) election.  This IRS rule permits companies to offer an early exercise of stock options. When making this election, you will pay income taxes on the fair value of your stock options. The early election is incredibly lucrative for founders and employers of early-stage startups with low fair market value.

The 83(b) election is rarely done due to the complexities in calculating the value of an early-stage startup’s options. If you can determine the value at the time of the grant and decide to pursue this road, you will owe taxes on your options’ fair market value at the grant date. But no income tax will be due at the time of vesting. Another disadvantage of this strategy is the risk of the employee stock price falling below the grant date level. In this scenario, it would have been advantageous to wait until the vesting period.

4. Navigate your taxes

Managing and planning your taxes is by far the most challenging step in the process of early stock option exercise. The biggest hurdle comes from the uncertainty about having enough cash to cover your tax expense. Further on, frequent changes in the company’s fair market value and inability to sell vested shares complicate the process of planning your taxes.

Given so many moving parts, you are probably wondering what your best course of action is. For one, once you reach this junction, it is time to ditch Turbo Tax (no offense, I used it for many years in the past) and seek expert advice. Despite all uncertainty about the future, we advise our clients to start making regular tax projections. Taking a snapshot of your current circumstances will allow you to take an objective view of your finances and make informed financial decisions.

5. Plan ahead for Early Stock Option Exercise

In my practice, I often speak with folks whose company is going public in a matter of days or weeks. A good number of them are considering exercising their stock options for the first time.

There is a strong appeal to do nothing until you approach a significant liquidity event. Waiting to exercise until the IPO eliminates a lot of financial and business uncertainty. However, the waiting strategy has a notable trade-off – paying higher taxes in the future and exposing yourself to material concentration risk.

The advice we give to all our clients is to plan ahead. Do not leave these critical financial decisions for the last minute. Even with the broad range of future outcomes, you could minimize your taxes and reduce your anxiety levels by taking small, measured steps.

What makes the Early Stock Option Exercise decisions so tricky is that no magic formula or one-size-fits-all solution works for everyone. While working with numerous clients, I realize that we all face different circumstances and challenges. If one approach works wells for your colleagues, it may not work very well for you. When we work with our clients, we try to strike the right balance between managing uncertainty and planning for the future.

Guide to understanding your job offer with stock options

Job Offer with stock options

Guide to understanding your job offer with stock options. Congratulations! You just landed your dream job. However, you might have one big puzzle to solve. Your compensation package includes a combination of a base salary and stock options. The news is exciting but also a bit confusing. What does owning stock options mean for your finances and career prospects?

The rules of stock options can be quite complex. Early decisions can substantially impact your future earnings and tax burden.

In this article, I try to break down some of the key points you need to understand before accepting a job offer with stock options.

Retirement Calculator

What are Employee Stock Options?

Employee Stock Options are a type of equity compensation. Many employers and startups, especially in the tech and biotech space, use stock options to reward and retain talented employees in a competitive hiring environment.

The options give you the right to buy company shares at a specific exercise price during your employment period. By exercising your stock options, you will become a shareholder of your company and participate in future success.

Being a shareholder of a successful company can guarantee your future financial prosperity. However, owning stock options and company shares will require a great degree of tax and financial planning.

What type of stock options – NSO or ISO?

There are two main types of employee stock options – Incentive Stock Options and Non-Qualified Stock Options. I have written two articles explaining each type.

  • For Incentive Stock Options, click here.
  • For Non-Qualified Stock Options, click here.

Comparing the two types, ISOs generally have a better preferential tax treatment over NSOs. The exercise of ISOs does not create a taxable income, but you may owe an Alternative Minimum Tax based on your overall annual income. The IRS allows you to treat your total realized gain as long-term capital gains as long as you hold your shares for 2 years after the grant date and 1 year after exercise.

For comparison, the NSO  exercise will automatically trigger a taxable event. You will immediately owe income taxes on the difference between the fair market value and the exercise price.

Another significant difference between the two types is that ISO can only be rewarded to employees. In contrast, companies can grant NSOs to employees, vendors, and other third parties.

What is your share of the equity?

Your job offer will include a specific number of shares you could own once you exercise your stock options.  As high as that number may look, it is a lot more important to know your percentage stake. You need to ask your future employer what is the company’s total number of outstanding shares. The number of your shares divided by the total number of the company’s shares will give your stake in the company. Also, keep in mind that your employer may issue new shares to external investors and VCs in the future, which can be dilutive to your ownership stake.

This information is critical, especially if you are joining an early-stage startup where the number of shares can be very fluid initially.

Vesting Schedule

Receiving the option grant does not immediately make you a shareholder. You can only exercise your stock options once they are vested.  The vesting represents the transfer of ownership from your company to you. Your employer will give you a vesting schedule with a series of dates. On each date or employment anniversary, you will receive ownership of a specific lot or percentage of stock options.

Keep in mind that you must exercise your stock options to own the company shares. Non-exercised options can potentially expire, and you will lose your ability to become a shareholder.

Strike price

Strike price or exercise price is the value at which you can buy the company shares once you exercise your stock options. You will be responsible for purchasing the shares. Fortunately, most startups set up the strike price near the $1 range. And most likely, the total cost will be deducted directly from your paycheck. The strike price is important because it will set the stage for your tax dues, depending on the type of stock option you own.

Fair Market Value

The Fair Market Value (FMV) is the price at which your company shares are valued at any given point in time. Your employer should provide you with a fair market value at the time of the stock option exercise.

The FMV of a publicly-traded company is straightforward. It’s typically the end-of-day market price on the stock exchange.

However, getting the FMV of a private company can be tricky. You will not have a publicly available price. For that reason, startups will hire a third-party expert to calculate the FMV based on recent rounds of funding, comparable company analysis, discounted cash flows, and expected revenue growth projections.

Early exercise

When evaluating your job offer, you can ask if your employer will allow for your stock options early exercise. Under IRC § 83(b) election, you can exercise your stock grants early and recognize them as compensation. This election can potentially save you taxes in the long run. The early exercise is especially advantageous for employees and founders of early-stage startups. By choosing early exercise, you pay income taxes at the low fair market value now. No income tax will be due at the time of vesting.  When you sell your shares, you will owe capital gain taxes on the difference between the sale price and the early exercise price.

Liquidity and exit strategy

If your future employer is a public corporation, you can easily sell your shares upon exercise. Selling shares can help you pay taxes on your earnings and diversify your investments.

The liquidity challenge occurs when you are working for a private company. There will be no public market for the stock. You must plan to hold your shares for a long period. Furthermore, exercising stock options can trigger certain taxes, which you will have to cover from your personal savings.

Vesting if the company is acquired.

Often startups are getting acquired before going public. Before you accept the job offer, you may want to know what will happen with your outstanding shares and stock options if your company gets acquired. In the most likely outcome, the acquiring company will cash in all your shares and options. It’s also possible that the acquiring company will exchange your employee shares and stock options for their own.

Termination

What happens with my stock options if I decide to leave the company? Usually, you will have 90 days from your departure to exercise your vested stock options.  Unfortunately, you will lose any nonvested stock options. It will be up to you to keep or sell any outstanding shares of the company.

Taxes

Finally, let’s talk about taxes. You will be responsible for all taxes resulting from the exercising of your stock options and selling your shares. Depending on the exact option type, you can owe ordinary income tax, short-term, long-term capital gain tax, or Alternative Minimum Tax.

In some cases, when exercising NSOs, your employer will automatically sell shares to cover all federal and state income taxes. In other cases, especially with private companies, you will have to pay taxes directly from your bank account.

Stock options taxes can be complex. You may face multiple scenarios depending on your company’s success. I strongly encourage you to be proactive and work with an experienced CPA or financial advisor who can objectively guide you through the tax planning process.

Incentive Stock Options

Incentive Stock Options

What is an Incentive Stock Option?

Incentive stock options (ISOs) are a type of equity compensation used by companies to reward and retain their employees. ISOs have more favorable tax treatment than non-qualified stock options. While similar to NQSOs, they have a few major differences:

  • ISOs are only granted to company employees.
  • They can only be vested for up to $100,000 of underlying stock value each year
  • ISO must expire after ten years
  • They are not transferrable
  • Long-term capital gain tax is due on the difference between the selling price and exercise price under certain conditions. To receive this tax benefit, ISO holder has to keep the stock for one year and one day after the exercise date and at least two years and one day from the grant date.
  • If the sale date does not meet the above requirements, ISO is disqualified as such and treated as NSO. In that case, you will owe ordinary income tax and short / long-term capital gain taxes
  • Options granted to shareholders with 10% or more ownership must be priced at least at 110% of the Fair Market Value and not be vested for five years from the date of the grant.
  • Alternative Minimum Tax is applicable on the difference between market price and exercise price in the year of exercise. You have to report the difference (also known as the bargain element) to IRS. This may have an impact on your final tax at the end of the year, depending on various other deductions.

Key dates

if you own ISOs, you need to keep track of these important dates:

Grant Date – the date when the options were awarded to you
Vesting Date – the date from when the options can be exercised
Exercise Date – the date when the options are actually exercised
Expiration Date – the date after which the options can no longer be exercised

Important price levels

In addition, you also need to keep a record of the following prices:

Exercise price or strike price – the value at which you can buy the options
Market price at exercise date – the stock value on the exercise date
Sell price – stock value when held and sold after the exercise date
Bargain element – the difference between market price and exercise price at the time of exercise

Tax Considerations of Incentive Stock Options

The granting event of ISOs does not trigger taxes. Receivers of incentive stock options do not have to pay taxes upon their receipt.

Taxes are not due on the vesting date, either. The vesting date opens a window for up to 10 years by which you will be allowed to exercise the ISO.

ISO exercise is not a tax event from the IRS perspective if you meet the holding period requirements by selling your stock after one year and a day after exercise and two years and a day after the grant date. Depending on when you sell the stock after the exercise date, six main scenarios can occur:

Scenario 1

You exercise your options and keep them. No tax due; however, you will have to make an adjustment for Alternative Minimum Tax for the amount of your bargain element.

Example: Let’s assume that you are granted ISO equal to 1,000 shares at the exercise price of $10. Your tax rate is 25%. On the exercise date, you exercise the options and decide to keep the shares indefinitely. The market price on that day is $15.

You are not required to report any additional ordinary income.

However, you must adjust your AMT for $5,000.

(15 – 10) x 1,000 = $5,000.

Scenario 2

You exercise your options and sell them in the same year, less than 12 months from the exercise date. This disqualifies your ISO and converts it to NSO. You will have to report ordinary income on your bargain element and short-term capital gain or loss taxes on the difference between the selling price and the market price at the exercise date. You do not need to adjust for AMT if you sell your ISO within the same calendar year.

Example: Let’s assume that you are granted ISO equal to 1,000 shares at an exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for three months in the same calendar when the price goes up to $18 and then sell all your shares.

You are required to report your bargain element of $5,000 as an additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25%, you will owe an additional $1,250 for taxes on $5,000 of extra income.

$5,000 x 25% = $1,250

You will also owe $750 on your $3,000 of short-term capital gains at your ordinary income level (See my posting about short and long term capital gains and losses)

(18 – 15) x 1,000 = $3,000

$3,000 x 25% = $750

Your total due to IRS will be $2,000

No AMT adjustment is due since you sold your shares in the same calendar year.

Scenario 3

You exercise your options and sell them in the next year, but less than 12 months from the exercise date. Your selling price is less than the market price at exercise. Since you sell less than a year after the exercise, your ISO is disqualified. Because your selling price is lower, IRS allows you to adjust your bargain element to the lower price

Example: Let’s assume that you are granted 1,000 shares at the exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for five months until the next calendar year when the price drops to $12 and then sell all your shares.

Your original bargain element is $5,000

(15 – 10) x 1,000 = $5,000.

Since the price dropped from $15 to $12, you are allowed to adjust down your bargain element to $2,000 and add it as additional ordinary income.

(12 – 10) x 1,000 = $2,000.

Since your tax rate is 25%, you will owe an additional $500 for taxes on $2,000 of extra income.

$2,000 x 25% = $500

Your total due to IRS will be $500.

You will also have to report an adjustment of -$3,000 ([12 – 15] x 1,000) for AMT in the new calendar year. This will “modify” your prior year AMT adjustment, which was equal to the original bargain element of $5,000.

Scenario 4

You exercise your options and sell them in the next year, but less than 12 months from the exercise date. Your sell price is higher than the market price at exercise. Since you sell less than a year after exercise, your ISO is disqualified.

Example: Let’s assume that you are granted ISO equal to 1,000 shares at an exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for 11 months in the next year…when the price goes up to $18 and then sell all your shares. Since you sold the shares before the 24-month mark, ISO shares are disqualified.

You are required to report your bargain element of $5,000 as an additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25%, you will owe an additional $1,250 for taxes on $5,000 of extra income.

$5,000 x 25% = $1,250

You will also owe $750 on your $3,000 of short-term capital gains at your ordinary income level (See my posting about short and long term capital gains and losses)

(18 – 15) x 1,000 = $3,000

$3,000 x 25% = $750

Your total due to IRS will be $2,000

 

You will also have to report an adjustment of $3,000 ([18 – 15] x 1,000) for AMT in the new calendar year. This will “modify” your prior year AMT adjustment, which was equal to the original bargain element of $5,000.

Scenario 5

You exercise your options and sell them after one year from the exercise date, but less than 24 months from the grant date. Since you sell less than two years after the grant date, your ISO is disqualified.

You will owe ordinary income and long-term capital gain taxes. Your total due to IRS will be $1,700

Example: Let’s assume that you are granted ISO equal to 1,000 shares at an exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for 18 months in the next year when the price goes up to $18 and then sell all your shares. Since you sold the shares before the 24-month mark, ISO shares are disqualified.

You are required to report your bargain element of $5,000 as an additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25%, you will owe an additional $1,250 for taxes on $5,000 of extra income.

$5,000 x 25% = $1,250

You will also owe $750 on your $3,000 of short-term capital gains at your ordinary income level (See my posting about short and long term capital gains and losses)

(18 – 15) x 1,000 = $3,000

$3,000 x 15% = $450

Your total due to IRS will be $1,700

You will also have to report an adjustment of $3,000 ([18 – 15] x 1,000) for AMT in the new calendar year. This will “modify” your prior year AMT adjustment, which was equal to the original bargain element of $5,000.

Scenario 6 

You exercise your options and sell them after one year from the exercise date, and after 24 months from the grant date. Since you meet the requirements for ISO, your sale is qualified.

Example: Let’s assume that you are granted ISO equal to 1,000 shares at an exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for twelve months after the exercise date and 24 months after the grant date when the price goes up to $18 and then sell all your shares.

You are allowed to report $8,000 of long term capital gain.

(18 – 10) x 1,000 = $8,000.

You will also owe $1,250 on your $8,000 of long-term capital gains at either 0, 15%, or 20%. Most people will have to pay 15% (See my posting about short and long term capital gains and losses)

$8,000 x 15% = $1,250

Your total due to IRS will be $1,250.

You will also have to report an adjustment of $3,000 ([18 – 15] x 1,000) for AMT in the new calendar year. This will “modify” your prior year AMT adjustment, which was equal to the original bargain element of $5,000.

How to minimize the tax impact of Incentive Stock Options?

  1. Meet the holding period requirements for one year after exercise and two years after the grant date. This will give you the most favorable tax treatment.
  2. Watch your tax bracket. Your tax rate increases as your income grow. Depending on the vesting and expiry conditions, you may want to consider exercising your options in phases to avoid crossing over the higher tax bracket. Keep in mind that tax brackets are adjusted every year for inflation and cost of living.
  3. AMT breakeven – you can exercise just the right number of shares to remain below the AMT tax level. Most accounting software will be able to calculate the exact amount.
  4. Use AMT credits when applicable. In the years when you pay AMT, you can rollover the difference between your AMT and regular tax due as a credit for futures years. The caveat is that AMT credit can only be used in the years when you pay regular taxes.
  5. You can donate or give as a gift your low-cost base stocks acquired through the exercise of ESO. You have to follow the holding period requirement to get the most favorable tax treatment.

Non-Qualified Stock Options

Non-qualified stock options

What are Non-qualified stock options?

Non-qualified Stock Options (NSOS) are a popular type of Employee Stock Options (ESO) and a favorite tool by employers to reward and retain workers. NSOs are a contract between the employee and the employer giving the employee the right but not the obligation to purchase company stocks at a pre-determined price in a set period.

Non-qualified Stock Options are similar to exchange-traded call options (ETO) in the way they allow their owner to benefit from the rise of the company stock. However, there are significant differences. There is no public market for NSOs. They can be extended for up to 10 years, while most exchange-traded options expire within a year or two. Additionally,  the employer sometimes can change the strike price of the NSOS while this is not possible for ETO.

Another popular equity compensation is an Incentive Stock Option. Click here to learn more about ISOs

Who gets Non-qualified stock options?

Non-qualified stock options are usually granted to company employees, but they can also be given to vendors, clients, and the board of directors. They can be exercised at any time between their vesting date and expiration date. They offer more flexibility than Incentive Stock Options but have less favorable tax treatment. The key requirement set by the IRS for NSOs is that the exercise price can never be less than the fair market value of the stock as of the grant date. While that can be pretty straightforward for publicly traded corporations, there are several valuation caveats for privately held companies.

Keep track of these important dates

If you own Non-qualified Stock Options, you have to be very strategic and keep track of all dates associated with the contract. You should get a copy of your option agreement and read it carefully. The devil is in the details.

The dates you need to remember are:

  • Grant Date – the date when the options were awarded to you
  • Vesting Date – the date from when the options can be exercised
  • Exercise Date – the date when the options are actually exercised
  • Expiration Date – the date after which the options can no longer be exercised

In addition, you also need to keep a record of the following prices:

  • Exercise price or strike price – the value at which you can buy the options
  • Market price at exercise date – the stock value on the exercise date
  • Sell price – stock value when held and sold after the exercise date
  • Bargain element – the difference between market price and exercise price at the time of exercise

 

 Taxes for Non-qualified stock options

The granting event of NSO does not trigger taxes. Therefore, receivers of non-qualified stock options do not have to pay taxes upon their receipt.

Taxes are not due on the vesting date either. The vesting date opens a window up to the expiration date by when you will be allowed to exercise the NSO.

NSO exercise is the first tax event from an IRS perspective. Depending on when you sell the stock after exercise three main scenarios can occur:

Scenario 1

You exercise your options and sell them immediately at the market price. You owe taxes on the difference between the market price and exercise price multiplied by the number of shares

Example: Let’s assume that you are granted NSO equal to 1,000 shares at an exercise price of $10. Your tax rate is 25%. On the exercise date, you sell your shares immediately. The market price on that day is $15.

You are required to report your bargain element of $5,000 as an additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25% you will owe an additional $1,250 for taxes on $5,000 of additional income.

5,000 x 25% = $1,250

Your total due to IRS will be $1,250

Scenario 2

You exercise your options and sell your company share a few months later (but less than 12 months) at the current price on that day.

First, you owe taxes on the difference between the market price and exercise price multiplied by the number of shares. Second, you also owe short-term capital gain taxes on the difference between the selling price and the market price on the exercise date multiplied by the number of shares.

Example: Let’s assume that you are granted NSO equal to 1,000 shares at the exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for three months when the price goes up to $18 and then sell all your shares.

You are required to report your bargain element of $5,000 as an additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25% you will owe an additional $1,250 for taxes on $5,000 of additional income.

$5,000 x 25% = $1,250

You will also owe $750 dollars on your $3,000 of short-term capital gains at your ordinary income level (See my posting about short and long term capital gains and losses)

(18 – 15) x 1,000 = $3,000

$3,000 x 25% = $750

Your total due to IRS will be $2,000

Scenario 3

You exercise your options and sell your company shares one year later at the current price on that day.

First, you owe taxes on the difference between the market price and exercise price multiplied by the number of shares $5,000 ((15 – 10) x 1,000) as additional ordinary income. Second, you also owe long-term capital gain taxes on the difference between the sale price and the market price on the exercise date multiplied by the number of shares.

Example: Let’s assume that you are granted NSO equal to 1,000 shares at the exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for twelve months when the price goes up to $18 and then sell all your shares.

You are required to report your bargain element of $5,000 as an additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25% you will owe an additional $1,250 for taxes on $5,000 of additional income.

$5,000 x 25% = $1,250

You will also owe $450 dollars on your $3,000 of long-term capital gains at either 0, 15% or 20%. Most people will have to pay 15% (See my posting about short and long term capital gains and losses)

(18 – 15) x 1,000 = $3,000

$3,000 x 15% = $450

Your total due to IRS will be $1,700

Tax Impact Summary

  • The receiver of non-qualified stock options will pay taxes on the difference between the stock market value and exercise price at the time of NSO exercise. The value has to be reported as an additional ordinary income.
  • If stocks are sold immediately after exercise at the current market value, you only owe taxes on the difference between market and exercise value.
  • In case you decide to keep the stocks you will owe long-term or short-term capital gains taxes depending on your holding period.
  • If the stock goes down after exercise and you choose to sell, you can report a short-term or long-term capital loss. You can use this loss to offset other capital gains. You can also use up to $3,000 of capital losses to offset ordinary income (like salary, commissions, interest). The remainder of the loss in excess of $3,000 can be rolled over in future years.

IRC § 83(b) election

IRC § 83(b) election allows companies to offer an early exercise of stock options. When making this election employees will pay income taxes on the fair value of their stock options. The early election is especially lucrative for founders and employers of early-stage startups with low fair market value.

This election is rarely done due to the difficulty in calculating the value of the options. If you can determine the value at the time of the grant and decide to pursue this road, you will owe taxes on the fair market value of your options at the grant date. But no income tax will be due at the time of vesting. Another disadvantage of this strategy is the risk of the employee stock price falling below the level at the time of the grant. In this scenario, it would have been advantageous to wait until the vesting period.

What can you do to minimize your tax impact?

  1. Prioritize long-term vs. short-term holding period. Selling shares after holding them for more than 12 months will trigger long-term capital gains which have favorable tax rates over short-term capital gain rates.
  2. Exercise your options as close to the exercise price as possible. However, companies often set very low exercise price, and this strategy may not be viable.
  3. Watch your tax bracket. Your tax rate increases as your income grow. Depending on the vesting and expiry conditions, you may want to consider exercising your options in phases to avoid crossing over the higher tax bracket. Keep in mind that tax brackets are adjusted every year for inflation and cost of living.
  4. You can also donate or give as a gift your low-cost base stocks acquired through the exercise of NSO
  5. If the NSO options are transferable, usually restricted to family members, you can consider giving them away as a donation or a gift