Equity compensation is an excellent way to build wealth, offering employees the opportunity to purchase company stock at a discounted price or receive extra stock as part of their bonuses. This can significantly accelerate your wealth-building journey—if you manage it wisely.
However, equity compensation, including stock options and restricted stock units (RSUs), comes with a complex set of financial and tax planning challenges. Navigating these challenges on your own can be difficult, so it’s often beneficial to seek professional guidance. In this post, I’ll walk you through some of the most common mistakes people make with equity compensation and how to avoid them.
1. Waiting Too Long to Exercise Stock Options
When you’re granted Incentive Stock Options (ISOs), you benefit from favorable tax treatment. However, if you wait too long to exercise these options, the tax bill can escalate.
For instance, if you’re granted 10,000 stock options at $1 per share with a 4-year vesting period, your first opportunity to exercise would be after one year, when 2,500 shares are available. Let’s assume the stock price has increased to $5 per share. If you exercise all your shares at $1 each, you’d pay $2,500, and no tax is due unless you trigger the Alternative Minimum Tax (AMT).
If you wait for several years and the stock price jumps to $100 per share, exercising your full allotment could create a massive tax liability. For example, if you have a $99 spread on each of your 10,000 shares, you could face a $990,000 tax bill. It’s crucial to consider the risks of AMT and create a plan to manage your tax exposure.
2. Exercising Stock Options Too Early
On the other hand, exercising stock options too early can also be problematic, especially with private companies. If the company does not go public or get acquired, you may find yourself holding worthless options. The main risk of exercising early is that you might pay taxes on shares that you can’t sell for a long time, or ever.
Exercising options early might reduce your tax liability, but you need to consider whether it’s worth the risk of not being able to realize any financial return from those options.
3. Forgetting About AMT Credits
AMT can be painful, but it’s not all bad. If you pay AMT when exercising your ISOs, you may be eligible for an AMT credit, which can be used in future years when you sell the stock. Unfortunately, many people forget about this credit or fail to track it correctly. This is especially problematic if you’re managing your taxes on your own. Make sure you understand how AMT credits work and don’t overlook them when filing taxes in subsequent years.
4. Not Filing an 83(b) Election
An 83(b) election allows you to pre-pay taxes on restricted stock when it has little or no value. This strategy can help minimize taxes over time and start the long-term capital gains clock earlier. However, you must file the election within 31 days of receiving the restricted stock or options. Missing this window can result in significant tax consequences later on. Be sure to take advantage of this election if you’re granted early-stage stock options or restricted stock.
5. Ignoring Expiring Stock Options
When you leave your job, your ISOs typically convert to Non-Qualified Stock Options (NSOs), and you usually have only 90 days to exercise them. If you forget about these options or miss the window to exercise them, they can expire worthless. Alternatively, failing to realize that ISOs have turned into NSOs could result in a loss of favorable tax treatment. Stay on top of the timelines to make sure you maximize your options.
6. Underwithholding Taxes on RSUs
RSUs are generally withheld at 22% for tax purposes, but high-income earners often fall into a higher tax bracket (e.g., 37%). This means you could owe significantly more tax than what was initially withheld, leading to underpayment penalties and a hefty tax bill come filing season. If your RSUs are vesting in large quantities, it’s essential to plan ahead and make adjustments to ensure you’re withholding enough to cover your actual tax liability.
7. Paying Extra Taxes on RSUs Due to Incorrect Cost Basis
RSUs are taxed as ordinary income when they vest, but the cost basis should reflect the market price at the time of vesting. If your brokerage doesn’t report this accurately, you could end up with a $0 cost basis, meaning you’ll be taxed on the entire sales amount when you sell the shares—resulting in double taxation. Make sure your cost basis is updated correctly to avoid paying unnecessary taxes.
8. Becoming Too Concentrated in Company Stock
It’s tempting to hold on to company stock, especially if you’re passionate about the business. However, it’s risky to become too concentrated in your employer’s stock, as your financial future could be too dependent on the performance of one company. Even if you’re receiving more equity through RSUs or options, it’s important to diversify your portfolio to reduce risk. Selling some of your company stock to create a more balanced investment strategy is often a good idea.
Conclusion
Equity compensation is a powerful tool for building wealth, but it comes with its own set of risks and challenges. By avoiding these common mistakes—such as waiting too long to exercise stock options, underwithholding taxes on RSUs, or becoming too concentrated in company stock—you can better manage the financial and tax implications of your equity compensation. Consider seeking professional advice to create a strategy that maximizes your wealth-building potential while minimizing your tax liabilities.