Key takeaways
Equity compensation is a form of pay that gives you shares of the company’s stock or the potential to purchase shares at a favorable price in the future.
Examples include stock options, restricted stock units and deferred compensation.
If your job includes equity compensation, a financial professional can help you estimate the value of equity compensation and develop a strategy that maximizes your after-tax income.
When you are offered a new job, the amount you will take home with each paycheck is always going to loom large in your decision whether to say yes. But the income you may receive years down the line — from stock options and restricted stock, as well as deferred pay — can be just as valuable in the long run.
Equity compensation is an employee benefit that either grants you shares of the company’s stock or offers the potential to purchase shares at a discounted price. By granting this alternate form of pay, corporations are better able to retain top employees and give them a stake in the company’s success.
“Equity compensation is often a significant part of overall compensation and can be a real driver of future wealth,” says Daniel Willing, a senior wealth strategist with U.S. Bank Private Wealth Management. “It’s not something you can really ignore.”
“Equity compensation is often a significant part of overall compensation and can be a real driver of future wealth.”
Daniel Willing, senior wealth strategist, U.S. Bank Private Wealth Management
Unlike your annual pay, however, these alternate forms of income require a hands-on approach. Understanding how these incentives work can make it easier to compare employment offers and help improve your financial well-being as you move forward.
Stock options are contracts that give you the right to buy a fixed number of the company’s shares at a pre-determined price — known as the “strike” price — within a certain period. Stock options are not actual shares. Rather, they give you the chance to buy stock at a potentially favorable price in the future.
If the company’s stock rises above the strike price, you are getting a discount whenever you choose to exercise your options. You can then sell those shares to generate immediate income or hold onto them in the hopes that they will appreciate even more.
Equity compensation becomes available to you through a vesting schedule. That means you have to meet the requirements of the company’s vesting policy — notably, remaining with the company for a certain length of time — before you can exercise a certain number of options.
For example, in three years, your employer might grant you 10,000 options with a strike price of $25 that expire in 10 years. If you exercise all those options when the stock is trading at $35 a share, each option is worth $10 ($35 trading price minus the $25 strike price). In total, those options are worth $100,000 before taxes.
As the share price increases, options become more valuable. However, there is always the possibility that the share price remains flat or even falls. If that happens, your options could end up being worthless at expiration.
For job seekers, the unpredictability of the market can make it challenging to evaluate the value of stock options in your compensation package. “While no one can predict with certainty what will happen to the company’s stock price in the future,” says Willing, “working with a financial professional can help. Often, they have access to sophisticated modeling software that can estimate the value of each option that’s on the table.”
Once you are employed and your stock options start to vest, timing can be critical. Willing suggests reviewing your situation at least once a year can help ensure you maximize your reward. If you are fortunate enough to see your company’s stock jump above the strike price, you will want to weigh the potential for further gains against the risk of downward movement.
“Future volatility is going to be greater with smaller entities than larger, more established companies whose share price hasn’t varied much over the past several years,” says Willing. “If you’re working at a company whose share price has recently soared,” he adds, “it can be a wise move to lock in a portion of those gains now and take some risk off the table — even if you have plenty of time before the options expire.”
You should also consider working with a tax advisor who can help you understand the tax treatment of your grant, whether it is in the form of non-qualified stock options (NSOs) or incentive stock options (ISOs). Together, you can develop a strategy that minimizes your overall tax hit and makes your annual liability more manageable.
Compared with stock options, restricted stock units are a more straightforward form of compensation. Whereas options give you the right to buy shares later, RSUs are actual shares of the company’s stock that you are given if you stay employed with them long enough.
Unlike options, you do not have to worry about how to time your purchase since the shares are yours as soon as they vest. And there is no chance that RSUs will go underwater, which can happen to stock options when the trading value dips below the strike price.
RSUs may be more predictable than options, but you will want to be careful about how they fit into your overall financial plan. That is particularly important if they represent a significant percentage of your salary. “If you have these stock grants coming in for years, all in your company’s stock, that can be a risk,” says Willing.
When 20% or more of your total net worth is concentrated in a single company, it is usually time to develop a long-term wealth strategy for those holdings. If you are more risk-averse, you may decide to freeze, or even reduce, your exposure by selling company shares now or in the future. But there is no one-size-fits-all answer. “What matters is that you have a plan for your future and you are comfortable with the possible risks and rewards associated with it,” says Willing.
The tax treatment of RSUs is more straightforward than stock options, but knowing the rules is important here, too. Typically, there is no tax due at the time RSUs are granted; however, they are subject to ordinary income tax based on the current share price when they vest.
Often, employers will sell a certain percentage of the shares to cover any taxes that are now due. If you are eligible for 100 shares after a year of employment, you may only have, say, 80 in your account after the tax withholding.
Once you own the shares, they are subject to the same capital gains tax treatment as other stock. For example, if you receive stock at $50 a share and sell it at $75, you will need to pay capital gains tax on the $25 difference.
Deferred compensation plans also offer a way to push some of your compensation into the future, although they are fundamentally different than equity-based benefits. Here, you simply choose to delay when you receive some of your pay.
Typically, deferred compensation plans allow you to elect the percentage of income you would like to defer every year. You can generally invest those dollars at your discretion across several funds, similar to many 401(k) plans. At the time of election, you choose how you would like to receive the deferred compensation in the future — for example, as a lump sum or spread out over a number of years.
The main advantage to deferred compensation is that you do not receive the income until retirement, when you may be in a lower tax bracket. That makes these plans particularly attractive to executives and other high-income earners. Once your money is deferred, you do not owe the IRS until the funds are distributed.
“The tax savings are potentially huge,” says Willing.
There are some important caveats to deferred compensation. For instance, you generally have to stay with the company for a certain length of time — or even until retirement — before you are eligible to receive those funds. If you want to move to a different employer, you could risk forfeiting a substantial amount of wealth.
In addition, deferred compensation is not covered by the same federal laws that safeguard 401(k) plans. “If the company goes through bankruptcy, that money is not protected,” Willing says. You should weigh the potential pros and cons carefully before deciding to use this option.
Alternative forms of compensation, including equity-based pay, can potentially boost your net wealth, making it easier to reach your financial goals. Because equity compensation is more complicated than traditional pay, however, it’s important to do your homework.
A financial professional can help you better understand the opportunities and risks of equity compensation, so you get the most of your benefits package.
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