Equity compensation is a common way for companies to award and retain employees, and it can be a great benefit if you know how to take advantage of it.

But sometimes it feels like you need an advanced finance degree to figure out how this stuff actually works. 

In this two part series, we’ll talk through the most common types of equity compensation, how they are taxed, and some things you should consider when determining how your equity awards fit into your financial plan.

Restricted Stock Units (RSUs)

How they work

RSUs represent a promise to deliver company stock at a certain date. This date is called the vesting date, and it’s common for these awards to vest over 3-4 years on an annual, quarterly, or sometimes even monthly basis.

Once you reach the vesting date, you receive a portion of the shares that were granted to you (for example, you’d receive 25% of the shares granted if your RSUs vest annually over 4 years).

It’s important to understand that you receive a fixed number of shares at the vesting date – the value of those shares fluctuate as the company’s stock price moves, and this may have changed quite a bit (which could be good or bad!) from the time they were originally granted.

When the shares are vested, you are in complete control of them – you can decide whether you want to hang on to the shares or sell them and move the cash to a bank account, or invest it according to your goals. 

How they are taxed

RSUs are taxed when you take control of the shares on the vesting date. You pay ordinary income tax – similar to how you are taxed on your salary – on the value of the shares as of the vesting date.

Your company will likely withhold taxes either by holding back a certain number of shares (so instead of receiving the full 100 shares that vested, you only receive 70, for example) or by immediately selling a number of shares on your behalf (typically called “selling to cover”). Both the income and tax withholdings will appear on your W-2 at the end of the year.

Most companies default to withholding federal taxes on RSUs – and most other equity compensation and bonuses for that matter – at 22%. This means that tax withholdings for RSUs are not based on your W-4 and could put you in a position of having a big refund or big tax bill when you file your return. So if you don’t expect to be in or near the 22% tax bracket for the year, consider how these awards will impact your taxes.

Once the shares vest, any change in the value is considered a capital gain or loss. Short term capital gains (which are gains on shares that you’ve held for a year or less) are taxed at ordinary income rates, while long term capital gains are taxed at more advantageous capital gains rates.

Planning considerations

In many ways, RSUs are similar to receiving a cash bonus. The dollar value of the shares is taxed when they vest, and you have complete control over what you do with the shares at that time.

The one difference of course is that you own shares of your company stock and not cash. So once the shares are vested, you need to decide whether to sell them and convert them to cash or hold onto the shares.

In making this decision, it can be helpful to ask yourself this question: If you received a cash bonus in the same amount as the shares that just vested, would you use that cash to buy shares of your company’s stock? Or would you save or invest it in another way based on your personal goals?

For many people, the answer is no, you wouldn’t necessarily buy your company stock if you had some extra cash lying around. However, it can be reasonable to hold your company stock if it makes up a small portion of your overall savings. Just be sure you understand the potential risks involved and the importance of diversifying your human and financial capital.

Non-Qualified Stock Options (NQSOs)

How they work

Stock options differ from RSUs in that they give you the right to purchase shares of the company’s stock once the options are vested. Meaning you need to pay for the shares before you take ownership. 

The potential benefit of this type of equity compensation is that the price you pay for the shares, known as the strike price or exercise price, is set when the stock options are granted to you. 

So if the company’s stock price increases between when the options are granted and when they vest, you could end up buying the shares at a discount. But the opposite is also true, so if the stock price decreases in that time, the options are worthless since you could buy the shares at a lower price in the open market.

However, options typically don’t expire on the day they vest, so even if the stock price is below your strike price when the shares vest, you have until the expiration date to be able to exercise the options if the price increases.

Once you exercise the options by paying the strike price and taking ownership of the shares, you are free to sell the shares.

How they are taxed

Nonqualified stock options are taxed when you exercise the options. You pay ordinary income taxes on the difference between the exercise price and the value of the shares on the day that you exercise the options.

For example, let’s say your strike price is $10, and the value of the shares is $15 when you exercise options to buy 1,000 shares. You would then pay taxes on $5,000 of income ($5 difference between the stock price and the exercise price multiplied by 1,000 shares).

Your employer will withhold taxes when options are exercised, and at the end of the year, the income and tax withholding will appear on your W-2. The method of tax withholding can vary – you may be required to pay your employer the amount of withholding due, or your employer may reduce the number of shares you receive.

Similar to RSUs, most companies will default to withholding 22% for federal tax purposes.

After options are exercised, any change in value is considered a capital gain or loss, and the tax rate depends on how long you hold the shares.

Planning considerations

In general, when the stock price is greater than your exercise price, it makes sense to exercise your nonqualified stock options if you plan to sell them immediately and realize the gain. 

Alternatively, you could hold on to the shares, and you may see some tax benefit since any additional increase in the share price after you exercise is considered a capital gain. 

But, you have to balance that potential benefit with the risk that the stock price decreases below your exercise price.

For this reason, nonqualified stock options come with many of the same planning considerations as RSUs. If you wouldn’t have bought shares of your company’s stock if not for the options, you likely want to consider selling the shares after exercise and saving or investing the money based on your unique goals.

If you work at a private company, the decision around when to exercise your options becomes a bit more complicated. Even if the value of the shares is greater than your strike price, you may not be able to sell the shares to realize that value when the shares are not publicly traded.

In this case you have to balance the tax savings of exercising (because any increase in value after exercise is treated as a capital gain), with the uncertainty of whether your company will go public, be acquired, or provide you some other type of opportunity to sell the shares.

Part 2

In part 2 of this equity compensation 101 series, we’ll talk about incentive stock options (ISOs) and employee stock purchase plans (ESPPs).

Joe Calvetti is a CPA and the founder of Still River Financial Planning, a comprehensive, fee-only financial planning firm that specializes in working with young families and professionals. Click here to learn more about how we work with clients.

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Disclaimer: The information provided above is for educational purposes only and should not be considered financial, legal, or tax advice. You should consult with a professional for advice specific to your situation.