Written by Matt Benson, CFP®
The employer and employee relationship is constantly evolving and the ways employers look to compensate and motivate their valued employees has changed over the last few decades. Many of the retirees we work with rely on multiple guaranteed income sources (like pensions) to cover living expenses, but the situation for their children will be different.
There are 73% fewer defined benefit pension plans in existence today than there were 35 years ago, according to the U.S. Department of Labor. In the early 1980s, changes in tax code made it preferable for employers to start transferring the risk and administration associated with their pension plans to their employees via new 401(k) plans. 401(k)s are the predominate retirement savings vehicle today and do offer benefits to employees like portability and flexibility. Yet the need to attract and retain top talent remains, and we see more and more employers using a Long-Term Incentive Plan, or LTIP, to offer something extra to key employees. We have had many discussions about these plans with clients and, despite differences in plan construction, there are some common components. In this article I will focus on stock options and restricted stock units.
Stock options grant an employee the right to purchase company stock at a specified price for a specified period, usually 10 years. Options typically involve a grant date, an exercise date, and a disposition date, and the option’s value is tied to the fluctuating price of company stock. It is important to know whether the options are Incentive Stock Options (ISOs) or Non-Qualified Stock Options (NQSOs). For ISOs to qualify for preferential tax treatment, the employee must not dispose of the stock within two years of the grant or one year from the exercise of the option. If those rules are followed, the difference between the fair market value of the stock at disposition and the original exercise price, often called the bargain element, is taxed at the preferential long-term capital gain rate. An employee granted an ISO at $10 can exercise the option in a year at $15 and subsequently sell the stock a year later at $20, recognizing $10 in long-term capital gains. If the holding periods are not met, ordinary income tax rates apply.
Non-Qualified Stock Options are essentially additional compensation. They aren’t subject to the holding periods that ISOs are and the tax consequences of exercising these options show up on your W-2. Not all stock options plans are created equal and knowing the differences between them is critical to optimizing a financial plan.
Restricted Stock Units (RSUs) are compensation in the form of employer stock. They are generally part of an initial grant and then vest over a period of years, typically 1/3 of the grant each year for three years. When each portion of the RSU vests, ordinary income is due in the year of vesting and no decision needs to be made by the employee. The grants are often annual incentive plans and employees that have multiple active grants can have a lot of ordinary income to recognize depending on the size of the grant and value of the employer stock. Because RSUs are somewhat more predictable and scheduled than stock options, we find that, as some employees near retirement, they need to weigh the stress of their current work versus future compensation.
When you get the HR email that you are eligible for their LTIP, first congratulate yourself, and then let’s get something on the books to discuss a strategy that best fits your plan. These incentive plans can change the trajectory of your wealth, but a hasty decision, whether that be on timing or taxes, can be detrimental.
This content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.