Stock compensation is a powerful tool companies use to attract and retain employees by offering them a stake in the company’s success. From Employee Stock Purchase Plans (ESPPs) to Incentive Stock Options (ISOs), Restricted Stock Units (RSUs), and Non-Qualified Stock Options (NSOs), each type of stock compensation offers unique benefits, tax implications, and strategic opportunities.
In this guide, we’ll break down the essentials of each type, highlight their financial and tax impact, and share our insights on using stock compensation to align with your long-term financial goals.
Types of Stock Compensation
1. Employee Stock Purchase Plans (ESPPs)
What is an ESPP? Employee Stock Purchase Plans are a type of benefit that allows employees to purchase company stock, often at a discount, through payroll deductions. With ESPPs, employees can buy shares at a price lower than the market value—often 10 to 15% less.
Why ESPPs Matter
ESPPs are particularly appealing because they provide employees with a direct way to benefit from the company’s growth at a reduced cost. If the stock appreciates, employees stand to make a profit from the difference between the discounted purchase price and the higher market price.
Tax Considerations for ESPPs
The taxation of ESPPs depends on whether the plan is qualified or non-qualified and how long you hold the stock. If you meet certain holding periods, gains can be taxed at the favorable long-term capital gains rate. If you sell earlier, gains are generally taxed as ordinary income.
Truly Aligned Insight
We see ESPPs as a great vehicle for disciplined, consistent wealth-building. By purchasing shares regularly and at a discount, employees can steadily accumulate stock, but we also recommend balancing this with diversification in your overall portfolio.
Learn more with our Guide to Employee Stock Purchase Plans (ESPPs).
2. Incentive Stock Options (ISOs)
What are ISOs?
Incentive Stock Options are a type of stock option that can only be granted to employees. ISOs are unique because they offer potential tax benefits if certain holding requirements are met, making them appealing for long-term wealth building.
How ISOs Work
ISOs provide employees with the right to buy company shares at a predetermined price (the exercise or strike price). If the stock’s market price rises above the strike price, employees can exercise their options, buying shares at a discount.
Tax Implications for ISOs
ISOs have a special tax advantage: if you hold the shares for at least one year after exercise and two years from the grant date, gains are taxed at the long-term capital gains rate, which is generally lower than the ordinary income rate. However, exercising ISOs may trigger the Alternative Minimum Tax (AMT), so tax planning is essential.
Truly Aligned Insight
ISOs are an excellent way to accumulate wealth if managed carefully. We encourage clients to consider timing exercises thoughtfully and to avoid concentration risk by over-investing in employer stock. As always, ISOs should be integrated into a larger, diversified financial plan.
Learn more with our Guide to Incentive Stock Options (ISOs).
3. Restricted Stock Units (RSUs)
What are RSUs?
Restricted Stock Units are company shares granted to employees, typically as part of a long-term incentive plan. Unlike stock options, RSUs are granted as actual shares but come with restrictions on when they can be sold, usually tied to a vesting schedule.
How RSUs Work
RSUs become fully owned by the employee once they vest. After vesting, employees own the shares outright, which they can hold or sell.
Tax Implications for RSUs
RSUs are taxed as ordinary income when they vest, based on the stock’s market value at that time. This means that even if you don’t sell the shares upon vesting, you owe taxes as though you received cash income. To cover these taxes, many companies offer a “sell to cover” option. With sell to cover, a portion of your vested shares is automatically sold to cover the tax owed, allowing you to keep the remaining shares without an out-of-pocket tax payment.
Truly Aligned Insight
RSUs can provide valuable income and stability, especially if they vest steadily over time. We recommend creating a strategy for managing these shares post-vesting—especially if a significant portion of your portfolio is in your employer’s stock. Holding onto some shares can be beneficial, but diversification is key to managing long-term financial risk.
Learn more with our Guide to Restricted Stock Units (RSUs).
4. Non-Qualified Stock Options (NSOs)
What are NSOs?
Non-Qualified Stock Options are similar to ISOs but do not receive the same favorable tax treatment. NSOs can be granted to employees, contractors, or board members, making them more versatile.
How NSOs Work
NSOs allow employees to buy shares at a predetermined strike price. When the stock price rises, employees can exercise the options to buy shares at a discount.
Tax Implications for NSOs
The difference between the market price at exercise and the strike price is taxed as ordinary income, even if you don’t sell the shares immediately. Any additional gains or losses from holding the stock after exercise are taxed as capital gains or losses.
Truly Aligned Insight
NSOs require thoughtful tax planning due to the immediate tax impact upon exercise. For employees with large NSO grants, spreading exercises over time or consulting with a tax advisor can minimize the immediate tax burden and optimize long-term wealth.
Learn more with our Guide to Non-Qualified Stock Options (NSOs).
Why Stock Compensation Matters in Your Financial Strategy
Stock compensation isn’t just an add-on to your salary; it’s a significant part of your financial journey that can amplify your wealth, enhance your financial flexibility, and create opportunities for achieving long-term goals. But it also comes with risks, particularly if too much of your wealth is tied to your employer’s stock.
At Truly Aligned, we believe in the power of using stock compensation as part of a balanced financial approach that reflects your values and life goals.
Truly Aligned Approach to Stock Compensation:
1. Evaluate Your Goals
Every stock compensation decision should start with a clear understanding of your goals. Are you looking to fund a major life purchase, or are you focused on building long-term wealth? Each type of stock compensation can serve different purposes in your plan.
2. Strategic Diversification
Stock compensation can quickly lead to over-concentration in one stock—your employer’s. While it’s natural to want to support the company’s success, holding too much of any single stock can lead to unnecessary financial risk. We recommend creating a diversified portfolio where stock compensation complements your broader investment strategy.
3. Tax Planning
Taxes are often the most complex aspect of stock compensation. From timing exercises and sales to strategically holding or diversifying, tax-efficient planning can maximize the net value of your stock compensation.
4. Long-Term Perspective
Stock compensation rewards patience. Strategies like holding ISOs for favorable tax treatment or selling RSUs systematically can align with both short- and long-term goals. A well-planned exit strategy helps manage potential market volatility and preserves the value of your compensation.
Frequently Asked Questions
How do I know when to exercise my options?
Exercising options depends on your cash flow, tax situation, and company outlook. A wealth advisor can provide a tailored exercise strategy that minimizes tax impact and maximizes potential gains.
What happens to my stock options if I leave the company?
Typically, you must exercise vested stock options within a certain period after leaving, often 90 days. Unvested options are generally forfeited. It’s essential to review your company’s specific policies.
Should I hold or sell my shares after vesting?
This depends on your financial goals and risk tolerance. Holding may be ideal if you’re confident in the company’s long-term performance. However, selling some shares can free up funds for other investments and help reduce concentration risk.
Truly Aligned’s Take on Stock Compensation
At Truly Aligned, we view stock compensation as a unique opportunity to support your company’s mission while building personal wealth. By using stock compensation as part of a diversified strategy, you can enhance your financial security and gain the freedom to pursue what matters most to you.
Whether you’re navigating tax questions, timing exercises, or balancing concentration risk, we’re here to help you unlock the full potential of your stock compensation. Let us work with you to integrate stock compensation into a meaningful, aligned financial journey.