Chances are that if you’ve reached a point in your career where your employer has granted you Incentive Stock Options (ISOs) or Restricted Stock Units (RSUs), you’re doing great. Both ISOs and RSUs are reserved for highly valued members of a company, people that organizations really want to retain for a long time. So, first things first, nice work!
Equity compensation can be tricky, and handling your grants properly depends on a range of factors. This includes the technical side — your existing assets, debts, and tax bracket — as well as the personal side, including the risk you’re comfortable with and your financial goals. Wouldn’t it be nice to finally buy that house you’ve been looking at on Zillow? Or to retire early, take a vacation, start a family?
In both cases, it’s important to consider what it’s worth to you to stay with the same company for an extended period of time. If you absolutely love your job, or if the upside is sufficiently compelling, your equity compensation plays a big role in how you plan your life. You have all this money on paper, but how are you going to turn it into material goals? Should you hold onto the cash or fund a Mega Backdoor Roth?
Fortunately, this is the kind of process that our team can help people optimize. By developing a deep understanding of each grant and collaborating with clients, we help develop equity compensation strategies that are right for them.
In this article, we outline the essential properties of RSUs and ISOs, including how they work, potential upsides, potential downsides, and how to handle each. Whether you work for a large, established company or a startup on the verge of an IPO, we hope you find the information illuminating. Of course, if the article leaves you with questions, please don’t hesitate to schedule a call to discuss your equity awards.
What are Restricted Stock Units (RSUs)?
In the simplest terms, RSUs are units of stock that, according to a vesting schedule (i.e., a period of time or upon the completion of certain performance milestones), an employer administers to an employee as income. That is, on the shares’ vesting date, the grantee receives the full value of the shares, which is immediately taxable as ordinary income. As long as the company’s shares have value, RSUs always result in some amount of income upon vesting. ISOs are a bit more complicated, but we’ll get to them in a second. RSUs are more common at larger, established companies — if you work for a giant tech company, chances are you’re getting RSUs.
Generally, RSUs are the most straightforward type of equity compensation.
- Example: John works for Company X. In addition to his salary, Company X grants John an RSU plan in which he will receive 4,000 total shares in the company, received 1,000 per year for four years (this is a very simplified model — after the first year, actual vesting schedules often operate on quarterly or even monthly basis).
- Each of these years is its own vesting date; at the end of four years, the grant is fully vested. If, after year one, a share in Company X is worth $100, John would get $100,000 in income. Then, if by year two, a share in Company X is trading at $120, John would receive $120,000 in his next 1,000-share payout.
Most people opt to sell them immediately upon vesting, realizing a healthy extra chunk of income. But let’s say the first vesting increment happened during the very early days of COVID-19, when the market temporarily tanked and stock prices were uncharacteristically low. The good news is that John would recognize less ordinary income upon vesting. Assuming he is comfortable with the risk of holding the stock for a year before selling. Assuming the price goes up, any gains would be eligible for the more favorable long-term capital gains rate instead of the higher ordinary income tax rate.
John’s situation is pretty straightforward, but yours might be more complex. For instance, you may have multiple grants with different vesting dates. It’s also important to be mindful of tax withholding and lockup periods. In some cases, your employer will automatically sell a portion of the shares and withhold the proceeds for estimated taxes. This withholding is reported on your paycheck, but often this won’t be enough to cover the bill. You could even be subject to inadvertent underpayment penalties and/or a surprise tax bill when you go to file your return. With proper planning, this withholding issue can be addressed prior to the vesting date.
This is where we can provide guidance and expertise. Our team can help you envision a wide variety of possible financial futures and tell you exactly how different RSU moves will impact your ability to realize your goals. Through collaborative planning (aided by technology), years of experience handling similar cases, and a thorough comprehension of who you are and what you care about, we can help you make educated choices.
Now, buckle up, because RSUs’ cousins — ISOs — are a little bit trickier.
What’s an Incentive Stock Option (ISO)?
ISOs are a little bit more complex than RSUs, so here’s a quick index of terms to reference as you read:
- Grant Date — the date on which a company issues ISOs to an employee
- Vesting Date — the date, usually starting one year after the grant date, on which an ISO bearer may legally exercise their options, buying company shares at the strike price (defined below)
- Vesting Schedule — a schedule by which an employee receives their ISOs
- Offering Period — the length of time after the grant date in which an ISO bearer may exercise their options (usually 10 years for ISOs, but in some cases sooner if your employment ends)
- Exercise Date — the date on which an ISO bearer chooses to exercise their options
- Strike Price — the company’s share price on the grant date; the price at which the company permits the grantee to buy shares on the exercise date
- 409A Valuation — an appraisal conducted by an independent third party that determines the fair market value (FMV) of stock for companies which have not yet gone public
- Blackout Periods — times when an employer prohibits employees from exercising options or selling shares of stock; stringency depends on the employee’s role at the company
An ISO gives an employee the right to buy company stock later based upon the price of the stock at the time of the initial agreement. The value of ISOs is based on the difference between the company’s share price at the time of the grant and the company’s share price when the options vest. ISOs are favored by early-stage companies — often planning for an IPO — on the brink of considerable scaling.
- Example: Marsha is a software engineer for XYZ Cloud Corporation, a promising tech startup poised to go public. On June 1, 2019 (the grant date), XYZ granted Marsha 5,000 ISOs when the share price was $5 — a total value of $25,000.
- In exactly four years, after XYZ has gone public, when Marsha’s ISO vests, the share price has risen to $20 — a new total value of $100,000. Marsha opts to exercise her ISOs on June 1, 2023 (the exercise date), buying her shares for $5/share (the strike price) and selling them for $20/share, realizing a profit of $75,000.
- Marsha’s sale is commonly referred to as a ‘disqualifying disposition’; she will owe ordinary income tax on the $75,000 profit. For a deeper dive on how ISOs are taxed in different scenarios, see here.
Now, imagine that XYZ’s IPO hadn’t gone as planned, and on the vesting date, their share price had remained at $5. Marsha could still exercise her option on this date, buying her shares for $25,000, but it wouldn’t make sense for Marsha to sell her shares, because she would realize no profit. Fortunately, Marsha could potentially still have a 10-year offering period in which she could exercise her options before they expired. So, if in nine years and 364 days (May 30, 2032), XYZ’s share price miraculously rose to $100, Marsha could sell her shares at that time for $500,000 and make $475,000 of profit.
In both scenarios, Marsha was fortunate; in the years between the grant date and the exercise date, XYZ’s share price rose. That doesn’t always happen. Growth is never guaranteed. This is the risk inherent to ISOs – If the company’s share price doesn’t rise before the option expires, the ISOs are “underwater” — worthless. Or, if the share price does rise, but the ISO grantee elects to await further growth before exercising their option, the share price may plummet, obviating any potential gains that the bearer could have reaped had they sold when the price was high.
As with RSUs, there are a number of factors to consider as you plan out when to liquidate the shares granted to you, all with different tax ramifications. Once your options vest, you have to choose between buying your shares with your own cash or doing a cashless exercise in which you borrow money to buy your shares and then sell them right away. Cashless exercises may sound easier — and, for people with limited cash on hand, they are, but the gains realized from a cashless exercises are taxed at a higher rate than they would be if the shares were purchased with cash and held for longer than one year.
So, if you’re flush with cash (and bullish on the company), it probably makes more sense to buy the shares outright, and then figure out whether to sell them all right away, hold them all for a period of time, or sell them incrementally over a series of years. Again, all of this depends on the tax consequences, your financial circumstances, your spending goals, your personal preferences, and more. If leveraged properly, ISOs can be very remunerative. We can help you maximize their potential and make informed decisions.
Crossing The Finish Line
Pat yourself on the back, because you’ve just completed lesson #1 in the two most common equity compensation models. As you can see from the abundance of technical language and the brainpower it takes to understand the intricacies of RSUs and ISOs, achieving a thorough comprehension of equity-based compensation is no mean feat.
Determining how best to handle your RSUs/ISOs depends on much more than a solid comprehension of their different features. It means thinking deeply about your life goals. With careful planning, you can come up with a path best fitted to your values and goals.
As you wade through all of this information, remember – we’re here to help. Our expert advisors have the training and experience to help you understand and act according to your unique situation. By helping you plan well today, we can help you live well tomorrow.
For more information on how our firm can help optimize your future, or to schedule a call to discuss your financial planning needs, please don’t hesitate to contact a member of the Wealthspire team.
