Demystifying Employer Stock Benefits

Jun 2, 2022 | Additional Insights, Financial Planning, Nearing & In Retirement, Saving & Investing

Do you remember when employees envisioned their dream retirement being funded by their trusty pension plan? Prior to the late 1970s, employer benefits were slim and pension plans predominated the landscape of benefits packages. Since 1978, however, benefits began to change rapidly when defined contribution plans (such as 401(k)s) became a staple in retirement benefits. Subsequently, since the 1980s, the variety of company benefits has exploded, ranging from retiree healthcare to unqualified retirement plans to employer stock benefits. Employer stock benefits are sometimes the most complex of these options. Although they can be lucrative, these options can trigger negative tax consequences that may even outweigh earnings if not properly accounted for within an individual’s comprehensive financial plan. 

In theory, employer stock benefits are quite simple: your company gives you the ability to purchase their stock at a predetermined price. The complexity resides in how this benefit is taxed, when this benefit is taxed, and at what rate this investment is taxed. This means that taking advantage of employer stock benefits requires that you and your advisor discuss your tax liability on an ongoing basis. 

In this article, we demystify employer stock benefits, including the pros and cons of the following options:

  • Restricted Stock Units (RSUs)
  • Incentive Stock Options (ISOs)
  • Non-Qualified Stock Options (NSOs)

Before we continue, here are a few useful definitions of common lingo used in employer benefits:

Stock Grant: an award of stock given by a company to an individual to facilitate a goal or to incentivize performance

Vesting: when an employee acquires full ownership of an employer provided benefit

Strike Price/Exercise Price: a set or predetermined price at which an investment can be bought or sold

Restricted Stock Units (RSUs)

What are RSUs? 

Restricted Stock Units are a benefit in which your employer grants you stock.

How do RSUs work?

Generally, RSUs have a vesting plan and distribution schedule after certain milestones are hit, or after a certain amount of time has passed.

How are RSUs taxed?

RSUs are taxed in two ways:

  1. The year a RSU vests, the value of the RSU is taxed as earned income based upon the date that the RSU vests. 
  2. Not everyone sells their RSU upon vesting. If you choose to sell your RSU at the same price at which it was granted to you, there are no taxes. However, if you choose to hold the company stock after the vesting date, the investment has the same tax ramifications as if you purchased a stock independent from your company. 

If the stock is held for greater than a year, the profit is taxed as a long-term capital gain (0%, 10% or 20% dependent on your adjusted gross income). If the stock is held for less than a year, any profit is taxed as earned income.

Incentive Stock Option (ISOs)

What are ISOs?

An Incentive Stock Option is an employer benefit which gives you the ability/right to purchase your company’s stock at a predetermined price.

How do ISOs work?

Incentive Stock Options are “granted” to you at a prespecified “strike price.” In laymen’s terms, you are given the choice to buy your employer stock at a predetermined price, which is generally at a discount to the current trading price of a stock. This option is exercisable for 10 years after the options are issued (FYI: this date can be contingent upon continued employment with your company offering the benefit).

Example: 

  • May 02, 2022, 10 shares of ABC stock is granted at $10 per share
  • May 02, 2025, 10 shares of ABC stock is vested and eligible to be exercised at $10 per share (10 shares times $10 per share = $100)
  • May 03, 2035, 10 shares of ABC stock is vested but no longer exercisable

How are ISOs taxed? 

The tax on Incentive Stock Options is based on the amount of time you hold the investment.

  1. Stock is sold less than 1 year from the exercise date or less than 2 years from the grant date of your stock option.

If either of the above time periods are not met, any profit occurring from the sale of the stock acquired from exercising your stock option will be taxed as earned income.

Example:

  • May 02, 2021, 10 shares of ABC stock are granted at $10 per share
  • May 02, 2022, 10 shares of ABC Stock are exercised and purchased at $10 per share (10 shares times $10 per share = $100)
  • May 03, 2022, 10 shares of ABC Stock are sold for $20 per share generating a net profit of $100 ($200 profit on the sale minus the $100 exercise price)
  • $100 profit is taxed as earned income
  1. Stock is sold after being held for greater than one year from the exercise date and greater than two years from the grant date of your stock option.

If you meet both of the above time periods, any profit occurring from the sale of the stock acquired from exercising your stock option will be taxed as a long-term capital gain (0%, 10% or 20% dependent on your adjusted gross income).

Example:

  • May 02, 2019, 10 shares of ABC stock is granted at $10 per share
  • May 02, 2022, 10 shares of ABC Stock is exercised and purchased at $10 per share
  • May 03, 2022, 10 shares of ABC Stock is sold for $20 per share for a net profit of $100
  • $100 profit is taxed as a long-term capital gain (0%, 10% or 20% dependent on your adjusted gross income)

Non-Qualified Stock Option (NSO)

What are NSOs?

A Non-Qualified Stock Option, like an ISO, is an employer benefit which gives you the ability/right to purchase your company’s stock at a predetermined price.

How do NSOs work?

A Non-Qualified Stock Option works similarly to an ISO: employer stock is granted to you at a predetermined price. The difference lies in the taxation of the benefit. 

How are NSOs taxed? 

Like ISOs, the tax rate assessed to the profit between the exercise price and the sale price is determined by the amount of time you hold the stock after the exercise date. 

If the stock is held for greater than a year, the profit is taxed as a long-term capital gain (0%, 10% or 20% dependent on your adjusted gross income).

If the stock is held for less than a year, the profit is taxed as earned income.

Unlike ISOs, the profit between the grant price and the exercise price is taxed as earned income in the year the option is exercised.

Example:

  • May 02, 2019, 10 shares of ABC stock is granted at $10 per share ($100)
  • May 02, 2022, 10 shares of ABC Stock is exercised and purchased at $15 per share ($150)
  • May 03, 2022, 10 shares of ABC Stock is sold for $25 per share ($250)
  • Profit between the grant price and the exercise price is $50 and is taxable as earned income ($15 exercise price minus $10 grant price = $5 per share, times 10 shares = $50)
  • Profit between the exercise price and the sale price is $100 and is taxed as earned income ($25 sale price minus $15 exercise price = $10 per share, times 10 shares)

Employer benefits are meant to be just that: a benefit. Unfortunately, if not properly understood, these benefits can cause tax consequences that dampen gains. It is also important to note that while tax issues can occur, any company’s stock is not guaranteed to increase in value. Lastly, the ability to automatically invest in a stock can lead towards an overconcentration (greater than 10%) of a company’s stock in an individual’s portfolio, which can cause an overreliance on one’s company. Risk increases when your salary, healthcare, and investments are all tied to one institution. 

Clearly, employer stock can be a fantastic benefit and one that can help employees accumulate a great deal of wealth. However, it is important to know the pros and cons of each type of stock benefit plan. Although these plans can provide tremendous benefit, they can create unintended consequences to your overall financial picture without being properly informed. Having a customized financial plan that incorporates the benefits of these plans while limiting their risks can help investors see employer stock benefit plans as complimentary, not complicated. Talk to your GreenUp advisor about how participation in employer stock benefits might impact your financial plan.

Author

  • Daniel Greulich, CFA, CFP®

    Chief Investment Officer | Wealth Advisor | Ann Arbor, MI -- Daniel leads our Investment Committee and partners with Aaron Kirsch, Chief Client Advocacy Officer to design and implement client portfolios with your advisor. Daniel brings 14 years of practical experience as a trader, financial advisor, and money manager at both large and mid-sized financial services companies to GreenUp Wealth Management. In addition, he holds a CFP® designation and is also a CFA charterholder. This combination of experience and knowledge helps Dan confidently guide his clients through the development, execution and monitoring of their customized financial plans.

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