June 2025
Tune in if you're interested in...
• The different types of equity compensation: non-qualified stock options, incentive stock options, restricted stock units, and employee stock purchase plans
• How vesting schedules work
• How to optimize equity for taxes
Watch previous episodes here:
Ep. 141 10 Principles Every Wise Investor Should Follow
Ep. 140 Taxes, Debt & The Future: What the New Budget Bill Means for You
Hello, everyone, and thank you for joining us for another episode of THE FINANCIAL COMMUTE. I'm your host, Chris Galeski, here to join me in the conversation around equity compensation is my partner and wealth advisor Mike Rudow. Thanks for joining me now.
Thanks for having me. I get excited whenever I get to be, a guest because I'm such a big fan of yours. And, it also gives me an excuse to shave and shower and brush my teeth. And these are all important things to do.
You're a beauty. One of the areas of financial planning or conversations that we love to have with clients is around equity compensation. It can be complex at times, but, you know, people often have a large part of their own individual net worth tied up into it. It becomes a serious conversation. And with that serious conversation comes a taxable impact.
And so these conversations are just a lot of fun from my perspective.
Yeah. And I mean, one, let's get an understanding of what equity compensation is. And it's pretty straightforward right? It's a non-cash payment of ownership in a company. And it could be to a private company or a public company. And you know, one thing that I know best about equity compensation is that I don't get equity compensation. But it's okay.
We can talk about that.
We can agree to disagree. You are a partner here. So you have equity and you have distributions.
It wasn't given to me. Yeah.
It's a little bit different. But equity compensation is often you know, a form of payment and sometimes to kind of have an alignment of interests, but also kind of keep really good talent within the organization for a long period of time. Yeah. What I found was interesting through the research that he ended, was that about 87% of public companies offer some form of equity compensation, whereas if you're a private company, it's only around 30%.
There are some reasons for that.
No, absolutely. And there are multiple ways you can use equity as compensation. Right. And well, I think we'll dive into each way that that can be presented to an employee. You've got non-qualified stock options, you've got ISOs, which are incentivized stock options, which is basically a qualified stock option. You've got restricted stock units, which are essentially stock as salary.
And then you've got an employee stock purchase plan, which is an elective, plan which allows employees to basically buy stock or equity into a company at a discounted rate.
Yeah. So let's start with the easiest one, which is the employee stock purchase plan. You know, it's kind of like contributing to your 401K. But during that period that you're having money taken out of your paycheck, you're purchasing stock during that window, oftentimes at a discount.
Yeah. So there's there's a program that's usually set up within a company. Most of the time these are publicly traded companies that offer their employee stock purchase plan. And it's only for employees who can't be a contractor or, someone on the board or something of that nature. But what you do is you essentially elect to sign up for this plan.
And now, just like your 401K, they're going to start pulling a portion of your money, out of your paycheck. That's going to go into a plot that eventually, usually six months down the road, will be used to purchase an amount of stock at a discounted rate. And one of the main benefits of that is that you're buying at a discount, right?
It could be a 5% discount. It could be ten. Usually, the max you see is a 15% discount. But another benefit of that is there's also a look back. So if your stock when you entered that plan for most plans was at $10 a share. But after six months, once now your money has been accumulated and it's purchasing those stocks and you look back and the stock is now $15.
A lot of plans will allow you to maintain that initial purchase price of $10 and discount that, right? So if it's a 15% discount, you're buying it at $8.50. And now it's a $13 stock. It's a pretty big advantage. But the things that you also want to think about with ESP is the tax consequences on that.
Because the IRS doesn't like to give you anything for free.
You're buying something at a discount. Right. And you bought it for 815, and it's worth $13. It's possible that that discount is taxable depending on if it's qualified or non-qualified. And what makes it qualified or nonqualified is... there's essentially a vesting schedule. So you need to hold on to that stock from at least two years from when you entered the plan and then from at least one year from when you actually purchased the stock.
And if you don't... if you sell it before that schedule, then that portion of the discount becomes taxable. And it's basically like ordinary income. And there's also an EMT adjustment for that part of it. Usually, it's not that large of a number because the max that most employers will allow you to go into is around $25,000.
But it's just something to think about. It's not just free. It's not a free discount that you're getting. But if you hold on to it for this qualification periods and, that essentially disappears and any gains that you have then moving forward will be capital gains.
And a lot of these studies say that, hey, if you have employees that are owners of your stock, but they are more involved in the business, they're more interested, excited to come to work. And you know, if that's stock as well. I think a lot of the baristas at Starbucks, they have that employee stock purchase plan available to them.
Yeah. You know and all of a sudden they're like, wow. You know this company has done well. I've done well. It's a way to kind of bring energy into the company.
Yeah. You want everyone rowing the boat in the same direction. Right. And if you're, you know, net worth is you know, tied up 10% in your company, you're, you're pulling for that company to do better so that the value of that stock continues to increase and your net worth continues to increase.
So there's all there's a lot of other studies that say, you know, the average person that has some form of equity compensation, I think it's primarily non-qualified stock options, incentivized stock options, or restricted stock units. Around 32% of their overall net worth is tied up in the company stock. That's relatively high. And, yeah, we should pay attention to overconcentration in one company.
Let's talk about restricted stock units. I love restricted stock units because it's easy from my perspective. Yeah, it's no different than a cash bonus. But instead of a cash bonus, you are getting shares of the company stock. And it's your choice whether you want to continue to own it. Be it vesting date or not.
Yeah, well, like you said, when you get a cash bonus, it's there in cash. You can use it. You could save it, you can reinvest it. But one thing is guaranteed is you're going to be paying tax on that, right? Ordinary income tax, payroll tax, that's getting taxed. When you're receiving RSUs, the second that they vest, no matter what you do with it, you're getting taxed on that, just like it's normal compensation.
And a lot of people don't realize that, that when they're receiving these stock shares, they're taxed as if that was salary. And so here's where that could be. A problem is say you receive, you know, $30,000 of RSUs and that vests. And now you just recognize $30,000 of income. What if the stock goes down 10% the next day?
Now you have $27,000 that you're paying $30,000 of tax on. There's an associated risk with that that people really don't understand when they're doing planning around these things. A lot of times you think, oh, I got RSUs. I'm just gonna hold on to the stock, right? Which is why you see such a high concentration. 30% of people's net worth tied up into their business.
And it's not necessarily a bad thing to hold on to some of that, but maybe looking at the areas that you have opportunity to accumulate equity in a company, it doesn't always have to be through RSUs. It can be through an ESPP, it could be through non-qualified or incentivized options, right where it's a different tax treatment. Because the last thing you want to do is pay tax on money that you never actually got.
Well, and that's why I like to ask the question. When somebody is receiving restricted stock units, oftentimes they're given to them and they vest over a 3 or 4 year period where you're getting a 30 year for three years, or 25% a year for four years. Yeah. And I ask them the simple question, if you got this money in cash today, would you buy the stock at this price?
If your answer is no, you should probably sell it. Yeah. And oftentimes, you still have more stock that you own or that will be vesting down the road. But you know, with restricted stock units, they're pretty simple. They can get confusing. People think that they can't sell the shares, but once they are vested, they're yours.
You can do anything you want if you own the shares. After vesting for at least a year, any of that future growth can be taxed at long-term capital gains. But if you sell it within that first year of vesting, you're subject to the short-term capital gains rule, which could be ordinary income.
Yeah. And back to your original point. RSUs are used a lot for retention of quality employees. Yeah, right. Because a lot of times there's a 4 or 5-year vesting schedule and they know that they're getting, you know, 50 shares in six months, another 50 shares in 18 months, another 50 shares. And so, it keeps them motivated to stay with the business and continue to contribute because they don't want to leave money on the table.
So they might be getting outside offers because they're, you know, a talent in the industry. But they know that if they leave, those are gone.
So we talked a little bit about employee stock purchase plans and restricted stock units, they're the more simple forms of equity compensation. Now we get into non-qualified stock options, and ISOs, incentive stock options. These are often forms of equity compensation that keep higher-level executives sort of rowing in the same boat together. Then, if the stock does very, very well over a short period of time, you can create an enormous amount of wealth through these programs.
So let's talk a little bit about that. Let's start NQSOs. I think it's a little bit simpler.
It's easier to go to start with an ISO because it'll make ISOs make more sense. So with a non-qualified stock option, you're getting the option to purchase equity, usually over a vesting period. So let's give an example of I've got 100 shares of non-qualified stock options that are going to vest over five years. So we're going to have 20 vesting in each year.
And that's going to be an expiration of ten years.
Usually, there's a ten year expiration on that. Right. So now those are granted to me on a certain date. So I've got a grant date. And then they're going to they're going to have a grant price.
A grant price is essentially the price that you are going to pay once that vest, or you're going to have the option to pay it, right. You don't have to when they vest, it's an option. So let's call it $10. So I've got ten shares of NQSOs at $10 that are vesting in six months. Six months come by.
They have now vested. The stock is worth $30. Well, I'm paying $10 for a $30 stock. That stock is $20 in the money. That's a pretty good deal right? So with an NQSO, now I could elect to purchase those shares for $10 that are worth $30. But that $20, again, nothing is really free. That $20, the IRS is viewing as income.
So you're going to pay ordinary income tax on that. If you hold on to that and you don't sell the shares, hold on to for a year or anything past that is going to be, long term capital gains. If there's gains and you sell within a year, then it's going to be short term.
Yeah. Because you can exercise and hold the stock or you can exercise and sell the stock.
And there's a lot of other options where you can do like a cashless exercise, where you're selling enough shares to cover that $10 per share and then holding on to the shares or taking the cash for the rest of it. But there's another trap that people get into is, is they don't have enough withholding for taxes. So they're going to they're going to exercise their stock options, you know, maybe use that money, maybe hold the shares, sell the shares.
But then when they get their tax bill, a lot of times if they didn't do planning around it, they're surprised because that's recognized as ordinary income.
And oftentimes clients ask us, okay I've got restricted stock units. I have these NQSOs. I feel like I want to sell some of my stock and buy a home, remodel my house, save for retirement, and make other investments. What should I sell? And it's just not that simple, right? If the stock price is close enough to your grant price with the stock options, probably sell the restricted stock units first.
Right. If there's a big delta between the grant price on the stock option and what the stock is trading at today, your example, it was granted to me at $10, but now it's worth $30. There might be a reason to sell those non-qualified stock options.
Or at least exercise that option.
So there's ways that we look at it and it's not always cut and dry. Sell this one over the other one.
And here's another situation that you get when you see that extra, options vest. And now you have the right to exercise that option. And there might be, you know, $20,000 of ordinary income gains if you do exercise. And then it's like, oh, well, I don't know if I want to exercise this because I'm already in the top bracket.
Maybe the next year, I'm not expected to make as much income. I'll be in a lower marginal tax bracket, so I should wait to exercise. And that might be a good tax strategy. But there's another side of that coin too. And that's. But what if the shares fall, right? Because there's no guarantee what those shares are going to be worth tomorrow or the next week or the next month.
Right. So that's why it's important to have a plan and have an advisor that's looking over these things with you because there's tax strategy, but there's also risk that's associated with any decision that you make, whether it's exercising that option or not exercising that option, because there are no guarantees with the way the stock market works. So these are things to think about that a lot of people don't when they're looking at, you know, specifically non-qualified stock.
All right. So let's rephrase NQSOs. They're the option to buy a stock. Typically there's a vesting period three, 4 or 5 years to where those options vest over that time. And then you have the freedom to do what you would like with that option. Right? They have an expiration date where if you didn't exercise and sell within that ten-year window, you just completely lost that value.
Now, when you do exercise, it becomes a taxable event at ordinary income. What's the difference between that and an incentive stock option?
So everything is basically the same in an incentive stock option except that ordinary income component. Just like when we were talking about the employee stock purchase plan. Some are qualified and some are not. So with an incentivized stock option, an ISO. If you hold the stock two years from grant and one year from exercise, well then where you normally would have paid ordinary income tax.
That example of that $10 grant price, $30 exercise price.
Yeah, that $20 that normally would be ordinary income is now... you're not paying any income tax on that for the time being. And then once that stock is sold, now the entire gain will be long-term capital gains. Yeah. Right. So it's a huge benefit from a tax perspective. But it's only if you're holding that stock position at least two years from grant and one year from exercise.
And then after that, now anything beyond that is long term capital gains.
ISOs are becoming more rare in the industry, and CXOs are a lot more popular. And it's interesting you go through times where companies will switch between giving restricted stock units and giving stock options. Yeah, and it's all because of stock price. If your company's stock price has been flat for ten years, all of a sudden the executives are going, I don't want these options.
They're not worth any value. Let's go to the restricted stock units. Whereas if you've got a company where the stock price is doing well, they're going to say, I want more stock options, less restricted stock units. It's fascinating how that shifts over. Yeah.
But it's also fascinating how markets can dictate what companies are doing because if you have an incentive stock option and if you don't meet the vesting requirement right, it just turns into a non-qualified stock option. And if you're in a really volatile market where your stock's going up 30%, down 20%, up 20%, a lot of times you're getting uneasy sitting and waiting because you're thinking like, my options are going to be worthless if I sit and have to hold them for this whole vesting period, right?
If I have to hold them for two years from grant and one year from exercise. So a lot of times what people were doing is they were taking their ISOs and they were ending up becoming and so non-qualified stock options anyway, because they were selling them the second that they were really profitable. Right. Because they didn't want to risk them being deemed worthless.
Yeah. Right. And so in volatile markets, a lot of times people don't have the patience to wait for that tax benefit because they'd rather take any benefit that they could get than lose, you know, free money.
Yeah. Mike, thanks so much for joining me for the conversation today. If you're out there and you get paid any sort of equity compensation from stock options to restricted stock units to the employee stock purchase plan, please reach out to your Morton Wealth advisor. We'd be happy to have a conversation with you.
nformation presented herein is for discussion and illustrative purposes only. The views and opinions expressed by the speakers are as of the date of the recording and are subject to change. These views are not intended as a recommendation to buy or sell any securities, and should not be relied on as financial, tax or legal advice. You should consult with your attorney, finance professional or accountant before implementing any transactions and/or strategies concerning your finances
