Employee stock plans can be a significant benefit to your net worth but you must know how best to use them for your situation. There are a variety of employee stock plans and each has their own benefits and considerations.
The most common types of employee stock plans are stock options plans, restricted stock plans, and employee stock ownership plans (ESOPs). Each of these plans are structured differently, have distinct tax implications, and different rules around liquidating shares.
Each plan has its own vesting schedule, which is the period of time between the date the stock is awarded and the date the employee owns the stock (or stock option). The vesting schedule could stretch years from the award date and the stock grant could be canceled in the vesting period for reasons like termination of employment or failure to meet certain goals.
Stock Options Plans
Stock options plans are a common way to reward employees as an alternative to cash. They function as call options, giving the employee the right to buy a certain amount of company stock at a set price (known as the strike price). Most options plans come with a vesting schedule so options may be awarded with a waiting time before the employee can exercise them.
An option on a stock may have a strike price below the current market value (called being “in the money”) or it may be above the current market value. Once the call option is exercised the stock shares are purchased at the strike price and employees can sell the stock immediately or hold it.
There are two common types of options plans: non-qualified stock options (NQSOs) and incentive stock options (ISOs). Incentive stock options plans have more favorable tax treatment and come with more stringent rules.
In an ISO plan, employees must exercise the options within 10 years of the award date or they lapse. If exercised, there are two parts the employee may be taxed on: the bargain element and the gain or loss in value post-exercise. The difference between the strike price and the price of the stock the day the options are exercised is the “bargain element.” If the shares are not sold immediately, the difference between the stock price at exercise and the sale price is taxed as a capital gain.
If an employee exercises the option and then holds the stock for more than one year from the exercise date and two years from the grant date, the bargain element and the capital gain are both taxed at long-term capital gains rates. If the stock is sold before the one- and two-year periods, the bargain element is taxed at ordinary income rates which are always higher than long-term capital gains rates.
Since the employee uses their own money to buy the stock at exercise, there are no tax implications under an ISO plan until the stock is sold.
In an NQSO plan, the employee is taxed at ordinary income rates on the difference between the strike price and the stock price at exercise, no matter how long the stock is held. Any gain on the stock after purchase is then taxed at capital gains rates when the stock is sold.
Restricted Stock Plans
Restricted stock plans are a way for a company to award stock directly to employees as a form of compensation. Rather than employees receiving options to buy stock, they receive actual shares of the stock on the date of the award.
The value of the stock on the vesting date is included in the employee’s W-2 income and this becomes the cost basis of the stock investment. When the employee sells the stock, their gain is taxed as a capital gain.
Employees may have the option to be taxed on the value of the stock at award, rather than at vesting. If the stock value increases between award and vesting, this shifts more income into the more favorable capital gains rates. However, if the stock never vests due to termination of employment, the employee does not get to undo this election and has paid taxes on a benefit they never received.
Restricted stock units (RSUs) are similar to other restricted stock plans but employees do not receive any stock until the vesting date. Those with RSUs do not have the choice of paying taxes on the award date and must pay taxes on the value of the stock at the time of vesting.
Employee Stock Ownership Plans
An employee stock ownership plan (ESOP) is a retirement plan and therefore has its own set of tax implications. Employees are not awarded stock outright, but are rather credited a certain amount of stock held in an account administered by a trustee.
When the employee leaves the company, the vested stock units are then “bought” by the company so the employee receives cash. The employee can choose to receive this in a lump sum or in payments over time. Withdrawals are taxable as ordinary income in the year received and employees may pay a penalty tax for withdrawing before age 55.
Employees can decide to roll their portion of the plan over to an IRA, which may delay some taxation. Rather than being taxed on a lump-sum withdrawal, these benefits are then taxed according to IRA rules. An IRA rollover also allows employees to direct their own investments.
Employee Stock Purchase Plans
An employee stock purchase plan (ESPP) allows employees to buy company stock, often at a discounted price. Employees make contributions to the plan directly from their paychecks and cannot contribute more than $25,000 per year. Purchase dates are specified by the plan, allowing employees to contribute over more than one pay period.
Taxes on this type of plan are incurred when the stock is sold. If an employee sells the stock more than one year after purchase and two years after contributing, they pay ordinary income tax on the discounted amount and long-term capital gains tax on any additional gain. If this time period is not met, the entirety of the gain is taxed as ordinary income.
Employees in this type of plan are allowed to sell the stock at any point after the purchase date, though the tax treatment incentivizes them to hold the stock for at least a year. Because employees buy the stock with their own money, there is no vesting schedule and they can keep the stock into retirement or when they leave the company.
Employee stock plans can be a powerful tool for building wealth, but they come with complexities that require careful planning. Understanding how each plan works—along with its tax implications, vesting rules, and potential risks—can help you make informed decisions that align with your financial goals. Whether you are navigating options, RSUs, or an ESPP, call us at (858) 755-0909 to discuss your situation.