It can be overwhelming when you first start to receive equity compensation, especially if you’re working for a startup or a smaller company where they don’t have the resources to provide you education on maximizing your equity compensation. From taxes to financial planning, the best strategy entirely depends on your individual situation and what you’re looking to do. In this blog post, I’ll outline essential financial and tax planning tips for dealing with equity compensation, whether in the form of Restricted Stock (RSU) or Incentive Stock Options (ISO).

If you’re early in your career, with plenty of investing time horizon to take on risk, you may want to hold onto incentive stock options (ISOs) to leverage the potential time value. Whereas, if you’re later in your career, you may be looking to diversify to solidify your path to financial independence.

If you have a choice, all things being equal, you should prefer to be compensated in RSUs vs. equity options.

RSUs are more valuable than equity options because RSUs will always retain value (unless the share price drops to zero). Alternatively, if the share price drops below the exercise price (aka strike price), the options become out-of-the-money and therefore worthless. It is worth noting that even if you currently have out-of-the-money options, if there’s a long time until expiration, they still have “time value” and are worth keeping an eye on.

If you’re offered options vs. RSUs with different quantities, your decision should be based on your tolerance for risk + capacity for risk + expectations in share price growth. The latter is highly speculative, so make sure always to use a reasonable range of outcomes 🙂

Let’s address taxation concerning restricted stock.

When RSUs vest, you’re taxed as income based on the fair market value (FMV) on the vesting date. There would be no avoiding income taxation at vest unless you made an 83(b) election at grant.

What is an 83(b) election? An 83(b) election is a form you can send to the IRS within 30 days of being granted restricted stock awards where you elect to pre-pay taxes based on the FMV at grant so that you can avoid income taxation at vesting. Furthermore, if you sell at least one year from the grant date, you can be taxed at long-term capital gain tax rates, which are taxed lower than income tax rates. If you have the foresight to make an 83(b) election on restricted stock that you anticipate will increase substantially, you can save a substantial amount in taxes.

However, it’s important to note that you should be skeptical about pre-paying taxes via an 83(b) election on already publicly traded stock. With private stock, you can reasonably expect a windfall post IPO or acquisition; however, all growth expectations are priced in pretty efficiently with publicly traded stock.

Let’s address taxation concerning incentive stock options (ISO).

When ISOs vest, there’s no taxation unless you exercise them. If you sell to cover (or exercise with cash and then sell), you’re taxed as income on the difference between the exercise price and the FMV. The primary tax planning strategy most people look to take advantage of is optimizing for long-term capital gain treatment by exercising and holding (at least two years from grant and one year from exercise). However, it’s important to note that if you exercise and hold, you can create the potential for an Alternative Minimum Tax (AMT) liability depending on how large the spread between the exercise price and FMV. It’s essential to be aware of an AMT liability to avoid negative cash flow.

An overlooked issue with equity compensation, in general, is disregarding concentration risk for unvested equity. When considering diversifying an equity position, it’s important to factor in unvested equity if you plan on remaining with the company throughout the vesting schedule. If you’re looking to optimize ISOs for long-term capital gain (LTCG) treatment, don’t disregard your concentration risk for unvested equity. If you’re concerned with the fear of missing out when diversifying, remind yourself how much “illiquid skin in the game” you still have. Don’t compromise the path to financial independence. When you’ve won, stop playing.

When it comes to diversifying a concentrated equity position, you mustn’t let the “tail wag the dog” when making financial planning decisions. Optimize for taxes once you reduce your concentration risk to a level that won’t compromise your path to financial independence.

If you are anticipating a windfall via employee equity compensation, the first step is understanding what kind of equity you own. Figure out your vesting schedule so you can start to optimize taxes and get to the point where you can use the money to maximize your happiness + fulfillment.

The overarching theme to remind yourself is that concentration builds wealth, and diversification maintains it. Working with a financial planner to help quantify when “enough is enough” can help determine if you should be diversifying.

Equity ownership is the only path to financial independence. If you’re early in your career, make sure to prioritize negotiating your equity compensation over your salary. If you’re going to work your butt off for a company, make sure to align their incentives with yours!

If you’re looking for help with diversifying your company stock, optimizing taxes, and planning for financial independence, click here to start your free assessment.