On this episode of the Equity Compensation Guidebook we're going to talk about one of the most important components of equity compensation. Actually, it's one of the most important parts of any successful investing strategy. Taxes! And what better time to talk about taxes than the season opener for the 2021 filing year! If you know me, you know I have a mantra when it comes to investments and taxes... It's not what you make. It's what you keep. If you end up losing a good portion of your investment returns to taxes every year, you lose the effectiveness of compounding over time. While we do not have complete control over taxes, there are things we can do.
I'm going to start with some of the basics but we're going to stay relatively high level when it comes to the main components of equity compensation. Non-qualified stock options, usually called NSOs or sometimes just stock options. Restricted Stock Units, referred to as RSUs, and then finally Restricted Stock, which sometimes go by Restricted Stock Awards or Restricted Stock Grants. These are the big types of equity compensation and what we will cover today!
You will want to hear this episode if you are interested in...
Taxation of NSOs — What to know
The taxation of NSOs is pretty straightforward. Most stock options are not fully vested when they are granted. This means they are not fully exercisable. The rules of when and how you can exercise your options are contained in the stock option plan document your employer provides to you. Now that your options are exercisable, there are still no taxes to be paid. Basically, the IRS doesn't care until you exercise them. So you receive the non-qualified stock options, no taxes. Once they are fully vested, still, no taxes. Once you exercise them that's when taxes come into effect. When it comes to NSOs there are two terms to get comfortable with. The first is compensation in income, better known as ordinary income, and the next is capital gains.
RSUs and Restricted Stock
Restricted Stock are basically the same as RSUs, except you get the stock right away. However, you will forfeit the shares if you don't meet the associated conditions laid out by the employers. In the case of Restricted Stock, the shares are held in escrow. Although they're sitting it in escrow, you are still considered the owner so you get dividends and can vote as a shareholder. One more big difference between RSUs and Restricted Stock is that the 83B Election can be used with a Restricted Stock but not with RSUs.
Now for some of the tax specifics for RSUs. When your RSU is vested, you have to report the compensation income for that year. The income is a fair market value of the stock when you received it and it's reduced by any amount that you may have paid for it. This happens when the RSUs vest and not when they're granted.
Part two with RSUs comes into play when you sell and dispose of the shares. Fortunately, this is simple, if you've held those RSU shares after investing for at least a year and a day you're looking at long-term capital gains. If it’s a shorter period of time it results in short-term capital gains rates. Restricted Stock is a little more complex because of the 83B Election opportunity so check out the episode to hear more on it!
This week’s FLASHBACK: Ski trip
Today's flashback is a quick one about a ski trip I took while in undergrad. It was to Steamboat Springs. Recently here in Akron, we've received about two feet of snow in roughly a week. That's a lot of snow, especially as 16 inches of it came in one day. All that powder reminded me of the one and only time I've really skied in powder. I live in Northeast, Ohio. Our ski hills are rather small, maybe 300 feet of vertical, and it usually takes less than a minute to complete a "long run". The first trail I went on when we arrived in Steamboat, took over an hour to finish. My mind was blown! One day a group of us on the trip decided to try and ski some moguls and through the trees — bad decision.
None of us had experience doing this. Our skis were long, which is great for Northeast Ohio, but was an issue when you need to do quick turns. Finally, the amount of powder we had was just overwhelming. We'd get about a foot of fresh snow every night. One person in our group somehow started sinking in an area of untouched powder like it was quicksand! Eventually, a few of us were able to get him there. We had a good laugh and decided to stick to some groom trails the rest of the day.
I’m Dan Johnson, CFP®, founder of Forward Thinking Wealth Management. I run a flat-fee financial planning and investment management firm located in beautiful Akron, OH. Although I am in Akron, OH, I work with clients regardless of location. I cater to owners of equity compensation positions who are looking to organize their financial lives, keep more of what they make, and do the things they want in retirement and even now.