With an increasing number of companies are offering stock-based compensation, particularly Restricted Stock Units (RSUs) and Employee Stock Purchase Plans (ESPPs), as benefits, the overriding question on employees’ minds is how they should manage them for maximum benefit.
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Compensation earned in the form of company stock or options to buy company stock offers great opportunities to build wealth. When managed properly, these benefits can help with a down payment on a home, pay off student loans, pay for future college expenses or boost retirement savings.
How RSUs Work
An RSU is a form of a stock option offered to employees as a performance incentive. RSUs are designed to incentivize employees to stick around. They are essentially a grant of stock ownership by the company, which becomes available to employees based on a vesting schedule. Employees receive RSUs on a grant date, which is when the company pledges shares of the company with the promise to issue actual shares to you on a future date.
Until that future date, which is the vesting date, the shares are restricted and cannot be sold. Shares are vested based on a schedule dictated by the company, which can be based on length of employment or performance objectives. Vesting can occur all at once or as a percentage over time. When the shares do vest, it is treated as a stock purchase and you now own the shares at the price on the vesting date.
Because RSUs are a form of compensation, you are responsible for taxes on their value as of the vesting date. For example, if your shares on the vesting date are valued at $5,000, that amount is added to your taxable income and taxed in the year it is received. In most cases, the company will withhold taxes on the vesting date. If you hold on to your shares for more than a year, and they appreciate in value, you will pay more favorable capital gains taxes on the increase in value.
How ESPPs Work
With an ESPP, the company offers employees an opportunity to purchase shares of its stock at a discount, which can range from 5% to 15%. Employees may contribute up to 10% of their after-tax earnings to a maximum of $25,000 each year. Many plans offer a “look back option” which allows employees to purchase shares based on the price on the first or last day of the offering, whichever is lower. So, if a company offers a 15% discount and the share price increases 5% during the offering period, you could purchase the shares at a 20% discount, which is a substantial pretax gain.
Shares must be held for a minimum of two years before they can be sold at which time any gains are taxed at the capital gains rate. The part of the gain attributable to the discount are taxed as ordinary income.
For example, if the share price is $10 and you purchase it at a discount of 15%, your purchase price is $8.50 per share. After two years, you sell the shares at $12 per share, you would have a long-term capital gain of $2 per share and ordinary income of $1.50 per share.
The Best Way to Manage Your Stock Benefits
As everyone’s circumstances are different, there is no one right way to manage these stock benefits. However, there are certain risks that apply to everyone. The best way to manage your stock benefits is in the context of your personal financial circumstances, needs and goals. In other words, the benefits should be managed as if they were a part of an overall investment plan with consideration for your investment objectives and risk tolerance. So, what are the risks associated with these stock benefits?
Concentration risk comes from allocating too much of your money to too few investments. A sound investment plan requires broad diversification to minimize the negative impact of any one investment on your portfolio. Investing too heavily in a single stock, rather than a diversified portfolio of stocks, exposes you to the volatility of that one stock. Concentration Risk Not to mention that much of your financial well-being is vested in the company – your future earning, benefits and retirement savings. So, by investing in the company’s stock, you have literally put all your eggs in one basket.
Does It Even Make Sense?
To make a sound judgement on whether it makes sense to invest in your company’s stock, consider this: If your company gave you a cash bonus of $25,000, would you invest it all in your company’s stock? Unless you have some sort of inside information (which would be illegal) that your company’s fortunes are most certainly going to soar, you probably wouldn’t. Taking a lesson from the pages of history, consider the tens of thousands of employees of formerly high-flying companies, such as Enron, Radio Shack, and Lehman Brothers, who lost their life savings when their employers became insolvent. Yes, you will owe taxes when you sell your shares, but you shouldn’t let the tax tail wag the investment dog. With RSUs, you will owe taxes the day they vest anyway. With ESPP shares, you will owe taxes on the discount regardless and if you have a gain, it will be taxed at the more favorable capital gains rate.
What About Taxes?
The decision as to whether to sell or hold on to RSU or ESPP shares should be considered in the context of how it fits into your long-term financial objectives. In most cases, you are better off controlling how your money is invested. It may be more advantageous to move that money into a Roth IRA or a 529 College Savings Plan. If you are uncertain, meet with a financial professional to help you determine the best way to allocate your money.
The great news about the taxes when it comes to your stock options is that there are numerous strategies you can implement to minimize your tax liability as much as possible. It’s crucial that you speak to a professional to see what your options are!
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. Stock investing includes risks, including fluctuating prices and loss of principal. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.