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Does your employer offer a form of stock compensation that you're unsure about, such as stock awards or stock options? Understanding the key differences between stock awards and stock options is important for you to make informed decisions. In this comprehensive guide, we will delve into these two popular forms of equity compensation and explore their unique characteristics, benefits, and potential drawbacks.
Stock awards, often in the form of restrictive stock units (RSUs) are a form of compensation where companies grant shares to their employees. These shares are usually subject to vesting requirements and can offer long-term incentives for employees.
On the other hand, stock options, including incentive stock options (ISOs) and non-qualified stock options (NSOs), give employees the right to buy company stock at a predetermined price, known as the strike price, within a specified timeframe.
By understanding these differences, investors can navigate the world of equity compensation with confidence and make decisions that align with their financial goals.
We'll provide an in-depth analysis comparing stock awards and stock options, including a closer look at tax implications, risk factors, and strategies for maximizing returns.
If you're an employee considering what to do when you receive these forms of stock compensation, this post will provide valuable insights into what you need to know.
What are Stock Awards Including RSUs
Stock awards including the most common form which are restricted stock units or RSUs, are a form of equity compensation that companies provide to their employees. They provide an opportunity for employees to become shareholders in the company they work for. This can create a sense of ownership and alignment with the company's long-term goals.
Additionally, if the company's stock value increases over time, employees can potentially benefit from capital appreciation.They are typically granted as a way to incentivize and reward employees for their contributions to the company's growth and success. Stock awards come in the form of actual shares of company stock, given as part of an employee's compensation package.
Think of RSUs as a cash bonus that’s linked to the price of the company’s stock. RSUs are “restricted,” meaning they can't sell them until an employee meets the vesting criteria—typically in tranches over time with four years being common. The shares are worth the fair market value (FMV) of the company stock on the day they vest.
The number of shares granted to an employee can vary depending on factors such as job performance, seniority, and company policies. Since these shares usually come with vesting requirements, employees must meet the required conditions, such as remaining with the company for a specific period of time, to fully own the awarded shares.
How Do Stock Awards Like RSUs Work
There are two key dates to know for most stock awards like RSUs:
The grant date: When a company promises or awards “restricted” shares of stock to its employees.
The vesting date: When the shares are no longer “restricted” and become owned by the employee.
There are important considerations to understand about stock awards like RSUs, including their tax treatment and the potential risk of becoming overly concentrated in company stock.
First Consideration: Tax Treatment of Stock Awards Including RSUs
Employees may be subject to taxes when the shares vest or when they sell the shares. RSU compensation is calculated as the number of shares multiplied by the FMV on the day they vest and is taxed as ordinary income in that year.
If an employee holds the shares for a year or longer after vesting, any gain (or loss) is taxed as long-term capital gains. Shares held less than one year from vesting are taxed at short-term capital gains tax rates, which is the ordinary income tax rate.
RSU tax if selling the stock on the vesting date is: The # of shares vesting x price of shares = income taxed in the current year.
If held beyond the vesting date, the RSU tax when the shares are sold is: (Sales price – price at vesting) x # of shares = capital gain (or loss).
That’s why employees may want to consider selling them right away so that they are only paying ordinary income tax, rather than both ordinary income tax and possibly capital gains tax if the stock price increases.
How Does the Stock Award Tax Get Paid?
Most publicly traded companies will take out the number of shares needed to cover the withholding tax. Here’s what’s important to know about that:
Most companies don’t withhold taxes according to its employees' W-4 rate but rather use the flat IRS rate for supplemental income, which is 22% in 2024.
If the employee's tax rate is higher, they’ll owe more on that RSU compensation at tax time.
That’s why employees may want to withhold additional federal taxes from their paycheck, set aside cash to pay their extra tax bill or make quarterly estimated payments to the IRS if regularly receiving stock awards.
Second Consideration: The Risk of Stock Overconcentration
Stock concentration risk is having a significant portion of an investment portfolio concentrated in mainly one or a small number of individual stocks or a particular sector. If the stocks or sectors in which the portfolio is concentrated experience poor financial performance, market downturns, or other negative factors, it can lead to an oversize loss.
To illustrate, this chart shows the average annualized outperformance of stocks after they’ve become one of the largest in the S&P 500. The top 10 largest companies underperformed by an average of -1.5% over the subsequent 10 years.
Chart created by Dimensional Fund Advisors
Compared to Fama/French Total US Market Research Index, 1927-2021
Having an over concentration in company can reduce the dollar amount one has invested that will benefit from the power of long-term compound interest.
While most performance is driven by a handful of stocks, investing in an index of stocks still works by providing exposure to those handful of stocks. It eliminates the need to try to pick the handful of stocks that might generate most of the performance since the top stocks will be owned in the index.
What are the Challenges Posed by Concentrated Stock Positions?
Risk Exposure The most obvious and often cited challenge is the lack of diversification. Downturns can be caused by events that can’t be controlled by a company (think the 2020 pandemic or recent inflation), which can result in a large financial loss in the portfolio.
Emotional Attachment Having a large portion of a portfolio tied up in a single stock can create an emotional connection to that company. This bias can cloud judgment and make it difficult to make objective decisions about when to sell or manage the position.
Tax Implications Selling a large stock position, especially one that’s appreciated significantly, can have substantial capital gains tax implications. This consideration can deter investors from diversifying their position, even when it might be in their best interest—creating both a financial and behavioral challenge for investors to overcome.
Opportunity Cost The most overlooked challenge is the opportunity cost. By remaining heavily invested in a few stocks, investors potentially miss out on gains from other companies or sectors. Only about 4% of stocks make up the total U.S. stock market return. And a whopping two-thirds of all stocks underperform the total US stock market. There might be large gains on a concentrated position over a certain period, but it may be underperforming the broader stock market. While individual stocks can outperform the broad stock market, roughly 40% of all stocks have suffered a permanent 70%+ decline from their peak.
What are Stock Options
Stock options including incentive stock options (ISOs) and non-qualified stock options (NSOs) are another form of equity compensation that companies offer to their employees. Unlike stock awards, which provide actual shares of company stock at vesting, stock options give employees the right to buy company stock at a predetermined price, known as the strike price, within a specified timeframe.
Stock options are typically granted as an incentive to employees and can be a way to attract and retain top talent. They offer the potential for financial gain if the company's stock price rises higher than the strike price assigned during the option's exercise period.
The two main types of stock options include incentive stock options (ISOs) and non-qualified stock options (NSOs). ISOs are typically offered to key employees and have certain tax advantages. NSOs, on the other hand, are more commonly granted to employees at all levels and do not have the same tax advantages as ISOs.
Key Differences Between Stock Awards and Stock Options
When it comes to equity compensation, stock awards and stock options may seem similar on the surface. However, there are some key differences that can impact an investor's decision-making process. Let's explore these differences in more detail.
Ownership Rights
One of the primary differences between stock awards and stock options lies in the ownership rights they confer. With stock awards, employees receive actual shares of company stock. These shares represent ownership in the company and typically come with voting rights and dividend eligibility. This means that employees who receive stock awards have a direct stake in the company's success and can participate in decision-making processes as well as receive dividends.
On the other hand, stock options only grant employees the right to purchase company stock at a predetermined price. They do not confer ownership until the employee exercises their options, and even then, the ownership is based on the number of shares purchased through the option.
Tax Implications
Another important factor to consider when comparing stock awards and stock options is the tax implications. Stock awards are subject to immediate taxation based on the fair market value of the shares on the date of grant. This means that employees may be required to pay taxes on the value of the shares they receive even if they have not sold them.
On the other hand, stock options are generally not subject to immediate taxation at the time they're granted. Taxes are typically only triggered when the employees exercises their options and sells the underlying shares.
The tax treatment can vary depending on the type of stock option, such as incentive stock options (ISOs) or non-qualified stock options (NSOs).
Tax Treatment of ISOs
Employees typically don't owe any tax when ISOs are granted. When employees exercise their ISOs, they don't owe regular income tax on the difference between the exercise price and the fair market value of the stock unless they sell the stock in the same tax year.
However, it's very important for high-income earning employees to understand that they may be subject to the alternative minimum tax (AMT) in the year of exercise, depending on their overall tax situation. Being aware of whether this form of compensation can lead to the AMT can help employees plan ahead for a potentially higher tax bill instead of being surprised.
The real tax implications of ISOs arise when the employee sells the stock acquired through exercising the options. If the stock is held for at least one year from the exercise date and two years from the grant date, any profit made on the sale qualifies for long-term capital gains tax treatment, which is typically lower than ordinary income tax rates.
Tax Treatment of NSOs
The main tax difference in the tax treatment of NSOs compared to ISOs is that employees owe regular income tax on the difference between the fair market value of the stock at the time of exercise and the exercise price. Then when employees sell the stock acquired through exercising NQOs, any profit made is subject to either short-term or long-term capital gains tax treatment, depending on how long they held the stock after exercise.
Risk Factors
Of course, risk is inherent in any investment, and stock awards and stock options are no exception.
However, the risk factors associated with these two forms of equity compensation differ. With stock awards, employees bear the risk if they decide to hold onto the shares they receive. That's because the value of the shares can fluctuate over time, and if the stock price declines, the value of the stock awards could decrease.
On the other hand, stock options carry the risk of the stock price not reaching the strike price within the specified timeframe. If the stock price remains below the strike price, the options may expire worthless. This means that employees may not be able to exercise their options and therefore won't realize any potential gains.
Conclusion
In conclusion, understanding the key differences between stock awards and stock options is essential for making informed investment decisions. Stock awards like RSUs grant employees actual shares of company stock, providing ownership rights, voting rights, and dividend eligibility.
Stock options like ISOs and NSOs, on the other hand, give employees the right to purchase company stock at a predetermined price within a specified timeframe. In addition to ownership rights, tax implications and risk factors also differ between these two forms of equity compensation.
Consulting with a financial advisor and tax professional can provide valuable insights into your stock compensation plan so you can make information decisions about what to do with them that is tailored to your individual circumstances. By understanding the nuances of stock awards and stock options, you can make informed decisions that align with your financial goals and optimize your investment strategy.
To learn more about your stock awards or stock options, you can book a free call with Life Story Financial. For more money and investment tips like these, check out our free ebook series and sign up for our monthly newsletter.