Feb. 1, 2023

Your Guide to Stock Options: ESPPs, RSUs, and ISOs

Your Guide to Stock Options: ESPPs, RSUs, and ISOs

How to maximize your employee stock compensation.

Whether you’ve got access to an ESPP (Employee Stock Purchase Program) at work and aren’t sure if it’s worth your time, or your new job offer includes compensation via RSUs and ISOs, this week is dedicated to you. Strap in for a ride through Jargonarnia.

This week, I welcomed James Conole and Scott Frank—hosts of Real Personal Finance and holders of the prestigious CFP and CFA designations—to the show to help me break down this complicated world. 

They had some excellent tips that you won’t want to miss. For example, pretend your RSUs are cash—would you use a cash bonus to buy company stock? If not, sell 'em.

Let's get into it.

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Transcripts can be found at podcast.moneywithkatie.com.

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Katie: ESPPs, RSUs, ISOs? WTF. Whether you have no clue what any of these acronyms are, or you've got access to one or more of them and you have no idea what to do, this episode will be your primer on all things stock options. Welcome Back to The Money with Katie Show, Rich Girls and Boys. I'm your host, Katie Gatti Tassin. Now, if you're listening to this episode, you probably fall into one of three buckets. Number one: I don't know what the heck these acronyms mean, but I'm here because I'm curious…and a little bit frightened. Number two: I want to know how to get access to these things because I know they can be valuable. Or number three: I have access to them, but I really have no idea what to do with them. 

Lucky for you, we are gonna talk about most of this today. And if you are listening to this because you have successfully big-brained a company into paying you in a way in addition to your salary with potentially tremendous upside potential, well done, Rich Human, well done. You probably work in tech, but not necessarily, and you're maybe befuddled as hell about what these acronyms and all their related jargon mean. So we're gonna explore these three overly complex compensation methods—no doubt, the brainchildren of some Wall Street hotshot, so you are able to make the best choices possible about your ESPPs, RSUs, or ISOs.

I'm also going to get some help today from two CFPs who host the Real Personal Finance podcast, Scott Frank and James Canole, so they'll be popping in intermittently to offer the hashtag #professionalopinion in the midst of my expletive-laced explanations. Just kidding. There won't be any expletives, just jokes today. 

A quick word of caution: RSUs sound a whole lot like RSAs, or restricted stock awards, but those are actually different, lol, and we won't be covering them today because my brain only has so much juice. I'm sorry. Okay, we'll be right back after a message from the sponsors of today's episode.

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Katie: All right, let's talk about ESPPs. Sam jumped off the table, so I'm gonna say it again. Let's talk about ESPPs. Before we get into RSU and ISOs, which fall into the equity compensation category, since they are convoluted ways for your company to pay you with something other than, well, money. Let's talk about ESPPs. This stands for Employee Stock Purchase Plans, and they typically allow you to buy your company's stock at a discounted rate. So at first glance, this can look like a recipe for focusing way too much of your net worth on your employer's success, which is dicey, for the obvious reason that your paycheck is also dependent to some degree on your employer's success. So eggs, meet one highly concentrated basket. 

They are intended to be an employee perk that allows you to buy stock more cheaply, but they are technically not considered compensation in the same way RSUs and ISOs are. According to a company called Human Capital, 85.5% of information technology companies and 68.3% of healthcare companies in the S&P 500 offer ESPPs to their employees. And in the Russell 3000, it's 67% of IT companies and 60% of healthcare companies that provide them. So in other words, if you work for a large public company, the chances are good that you will have some variation of this option available to you. But there are many different ways to structure such a perk, and the way your perk is structured really matters. So depending on how your ESPP is set up, it might be a way to get some guaranteed returns on your money. 

Now, I am personally not a fan of them in general when used as intended, because, like we said, you're putting all your eggs in this one basket, but I do like the side door technique to guaranteed ROI if structured correctly. So let's take a walk down benefits planning lane, shall we? 

If your plan provides a discount, so typically it's gonna be up to 15% on the stock; allows you to accumulate your cash contributions over the defined accumulation period or offering period, usually between six and 12 months; and then buys the discounted shares of your company's stock on the purchase date and allows you to sell them immediately with reasonable trading costs—so think no restrictions, no blackout dates with bonus points, if your program will allow you to just automate that sale so it happens immediately, then you may be in a good position to take advantage of this little hack. So by allocating a portion of your income to a plan like this, you will guarantee a 15% return on your investment, minus ordinary income tax. For example, if your company's stock costs $10 per share and you get a 15% discount, your company would accumulate your cash contributions during each pay period over the length of the offering period. Then it would buy the shares for $8.50 each on the purchase date. So if you were able to place that “sell” order immediately, you are earning a guaranteed $1.50 profit per share, on which you would pay short term capital gains taxes come April.

Now, of course, you do have to weigh this priority with your other financial priorities, like contributing to your 401(k). Maybe you're also contributing to an HSA or a Roth IRA. But if you are in a position where you've checked your major boxes and you're looking for other hashtag #optimizations to make, it might be worth exploring whether or not your employer stock purchase program is structured in a way that would make this possible. Scott and James had some thoughts as well. 

Scott and James: You can purchase up to $25,000 worth of stock in a year. So usually you enter the program at the beginning of the open window, and then the window usually is either a year period or every six months. And while you're doing that, if something…normally it's written such that if something really terrible happens in your life and you need that cash, you can actually ask for it back and then you can just utilize it, but you won't get that benefit then, right? So for the period of time that the window has opened, which is usually annually, then you can't reenter until the next cycle. So long as you are allowed, and you wanna double check the documentation that you're allowed to sell and the windows are open, the moment your purchase occurs, the hack that people are thinking about actually happens. You can purchase something for $20, you know, $22 and a half, $22,500 gets you $25,000. You can sell it the next day for very little gain or loss, and you get to reap the reward. Essentially a 15% return. You have to pay taxes on it, but it's still a really nice return. So that is useful, but the thing to be careful about is to look at the rules and make sure that the rules and the way that the windows are structured will allow you to actually see that benefit. 

Yeah, and I think that after a 401(k) contribution up to the max, this is maybe the best use of your money from a return on investment standpoint. I guess, you know, if I have a 401(k) and I get a 3% match, if I put 3% in, I just got a 100% rate of return on my investment, because it got doubled by my employer. With the ESPP, you're getting a guaranteed return on your investment that you're not really getting anywhere else, if you do it correctly.

And I think the other benefit too is, you'll hear Scott and I talk about this a lot, of how can you automate your finances or how can you do stuff without having to consciously think about it? And this is one of those things where if I have to receive the money and on a monthly basis make the decision to go save it somewhere or invest it somewhere, I'm far less likely to do that than if it's, oh, the company's just withholding this, and then once every six months, I just need to set a reminder to go sell it right away and then do what I would otherwise do with those savings with a nice return investment locked in. 

Katie: All right. Now let's talk about RSUs, or restricted stock units. Frankly, these are a lot simpler than their ISO counterparts. RSUs are also the only fancy equity technique that I have been personally exposed to at Meta, when I worked there for *checks notes* three months, but I quit to do Money with Katie full-time before my first round of these shares would've even vested. C’est la vie. But it makes for a helpful example that we'll get to in just a minute. Restricted stock units began gaining popularity in the aftermath of the Enron and WorldCom scandals, when the Financial Accounting Standards Board—which sounds like the most lit job in the world, wow—declared that a company had to book an accounting expense when it issued stock to its employees. So the RSU that was previously reserved for hotshot management became more common for regular employees. So in layperson's terms, an RSU is just a way for a public or large private company to incentivize you to stick around longer, because they're paying part of your compensation in stock. 

But the catch is, you don't get the stock every two weeks on your paycheck, like the cash portion of your compensation. That would be too easy and totally defeat the purpose. Instead, your shares are delivered to you on a vesting schedule. Vesting schedule is just a fancy phrase that effectively means, the schedule on which they are ponying up the stock that you were promised, and companies get hella crafty with these vesting schedules. Sometimes your shares will vest on a quarterly basis; other times nothing will vest until you've been with a company for a year, and then they'll vest at a rate of once per month. Other times they'll tie vesting to individual or company performance, which honestly sounds really draconian. Anyway, if you're granted a thousand shares that vest over four years, it's likely you'll get the first 250 shares after year one, the second set of 250 after year two, and so on. But the paperwork that you receive should outline your vesting schedule, and if you quit after three months, like me, you probably won't get anything. See why they're an incentive play for you to stay? We'll be right back after a message from the sponsors of today's episode.

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Katie: All right, so how much are these things worth? At this point, you're probably like, cool, but how much are these suckers worth to me? Well, realistically, when you receive your job offer, the company will value your RSUs based on the company's stock price at the time. For example, if you're supposed to earn a thousand shares and shares are worth $20 at the time of your offer, they will tell you that your RSU compensation is worth $20,000 over our imaginary four-year vesting period. So $5,000 per year. But really, this number is kind of a shot in the dark. So my Meta example is actually perfect for illustrating this point. When I was granted my RSUs, it was about 140 shares. They were worth $50,000 over four years, because at the time, Meta’s stock price was around $352 per share. Today it's worth $118 per share. Crucially, and this is the key, they did not promise me $50,000 worth of stock. They promised me 140-something shares that were worth $50 grand at the time, given the company's share price of $352. But today, that same equity compensation would be worth around $16,000. 

All that to say, your RSUs will probably be worth something, even if the stock price plummets after you joined the company—totally coincidentally, obviously. But you might not wanna anchor to the value you're quoted when you receive your offer. Of course, this could go the other way, too. If you joined a company then the share price skyrocketed, your RSUs would be worth more than you were originally promised. And once they vest, they are yours forever. You can do whatever you want with them. You can keep them, sell them, turn 'em into an abstract art project. It's up to you. 

So at this point you're probably like, great, this sounds fun. How are they taxed? The important thing to know about RSUs is that you have very little control over when and how they are taxed, which is in many ways the reason that these are a simpler financial instrument. So we have a one-two punch with taxes on RSUs. Are you ready? Tax punch one is ordinary income tax. RSUs are almost always taxed like income when they vest. And I'm hesitant to say absolutely always, as this is an arena of compensation that is pretty hairy, but for the most part, you can expect to pay taxes on the fair market value of the stock at the time of vesting. This means that if your 250 shares vest, so for all intents and purposes, this just means, are delivered to you, for $20 per share after three months, this looks like $5,000 of compensation to the IRS, and is subject to all of your normal taxes. It's customary for some of the stock to be withheld and surrendered right away in order to pay the tax bill on the shares. But the important takeaway here is, most of the time you are taxed on this when it's awarded, regardless of what you do with it. So whether or not you liquidate everything or hang on for the long haul does not impact your up-front tax bill. 

That being said, there's also tax punch two, which is capital gains taxes. The second punch comes in the form of capital gains. If you hang on to those RSUs—so let's say you're a risky Rich Girl and you have not heard any of my diatribes about why it's probably unwise to hold a sizable portion of your net worth in individual stock or company stock, so you put it all on black, you hang onto those RSU for the long haul. And let's say you were wise to shirk my risk-averse advice because it worked out for you. Your company succeeds wildly, clearly in no small part because of your fantastic contributions, and your shares that were worth $5,000 at the time of vesting are now worth $20,000 many years later. If you were to turn around and sell your shares to cash out your fat stack of Gs, you owe capital gains taxes on the difference between the value at vesting ($5 grand) and the value at sale ($20 grand). So you owe taxes on $15,000. In this instance, you probably don't care that you're going to pay capital gains taxes, because you just made $15 grand for doing nothing. 

Now, if you were to sell your shares immediately at vesting, you would theoretically owe zero capital gains taxes, because you cashed out, you took your chips off the table right away. You did not give them a chance to go up or down, which is why this is usually the most quote unquote “responsible” option. I am not in the business of making recommendations about how to handle these complicated financial instruments, but the general best practice with RSUs is to sell—read, turn the shares into cash and diversify into something a little more suitable, like an index fund. Though it should be stated, this is like taking your chips off black and then spreading them out everywhere. Here's what Scott and James had to say. 

Scott and James: There's no unique tax benefit to holding RSUs after they invest. I think what we would tell clients to do or anyone to do, is when you receive RSUs, don't think of them as RSUs. Think of it as receiving a lump sum of cash. If you received a lump sum of cash and you would take that to go buy company stock, well, great, just let your RSUs vest and keep the company stock. But there's…people talk about the endowment effect, that we tend to value those things that we hold onto more than if we had to go purchase it new, or if we don't already have it. And so because of inertia, because of that, because of whatever, a lot of people tend to just say, oh, it's vesting. I'm not thinking about it. And it keeps doing its thing. But if you can consciously think of it as, “What would I do if this cash was given to me as a cash bonus? Would I save for retirement in another way? Would I pay down debt? Would I save for a home? Would I pay for a trip? Or would I buy my company's stock?” Unless my answer is “I would go buy company stock,” there's really not a good, compelling reason to keep your RSUs, because there's not a tax benefit for doing so, versus just selling them as soon as they vest. 

Katie: Scott and James also had a cautionary note about not succumbing to lifestyle creep when you begin earning RSUs. 

Scott and James: If you can live life on your salary and not rely on the RSUs, you're gonna build wealth really quickly. If you creep your lifestyle to the point where you need the RSUs to live life, it really takes away from flexibility for you in life. 

Katie: All right, it's time to cover ISOs, which means it is time to focus. If RSUs are the peewee football team, ISOs are the New England Patriots. We have a lot of jargon, lot of technicalities to cover, so wield your drug of choice—mine is a quad shot of espresso—and strap in. I had to crack open my dry-as-hell CFP books for this section, which is how you know that I really love you. 

ISO stands for “incentive stock option,” and the word “option” is key. It gives you, the employee, the option to buy company stock at a discounted price in the future, after your ISOs have vested. Do you remember vesting? Yeah, it applies here too. All of these fancy compensation methods are various forms of golden handcuffs. ISOs, though, can be a relatively risky gamble, depending on how you play it. There were plenty of stories in 2022 of employees exercising options in a rosier 2021 economy and holding their stock for the undoubtedly bright future of their company, only to see the value of their shares plummet in 2022—and then, painfully, owe taxes on suspected profits that *poof* vanished. Typically, ISOs are given to top employees of public companies, or companies that are about to go public. Once you receive your ISOs, you have to make the call about whether or not you're going to do anything with them within 10 years of receiving them. And the day that you receive them is known as the grant date. Your ISOs will come with a strike price, which is basically the price you are being given the option to pay for your company's stock. This strike price is key, because it's essentially what determines whether or not this is going to be lucrative for you. If the strike price is lower than the price of the stock on the stock market, you would probably consider exercising your options, or in layperson's terms, buying the stock at the strike price, because you could theoretically turn around and flip those suckers for a profit.

But if the stock is worth less on the public stock market than your strike price, you probably would not exercise your options, since you could, you know, log into your E-Trade account and pay less on the public market like everyone else. It's possible that 10 years could pass in this fashion and your ISOs would expire, totally worthless. It's also possible that between the grant date and the exercise date, when you're all vested 'n shit (oops, I said we wouldn't have any expletives, but I guess there was one). And you can exercise your option, your strike price is way lower than the current price of the stock, allowing you to buy a bunch of shares at a steep discount. So when companies explode in value and early employees are granted ISOs, this is a really good way to become a millionaire overnight, though this is the “winning the lottery” equivalent of equity compensation. This is not the norm. 

For example, let's pretend you're granted 100 ISOs at a strike price of $5. Once they vest and you're able to exercise your option, maybe the market price is $20 per share. So you can exercise your option to purchase a hundred shares at your strike price of $5 per share. So a $500 cash outlay by you to purchase shares worth $2,000. A hundred shares times $20 a share, right? The math is mathing. You could flip them immediately for a $1,500 profit, minus taxes. 

Now that example works if you're dealing with this question as an employee of a public company. If your private company that plans to go public at some point in the future has granted you ISOs based on their independently conducted valuation, called a 409A, it's a little trickier. If you're facing this dilemma and need to make a decision soon, I would probably reach out to a fee-only hourly CFP or CPA who can help you make sense of your decision, as choosing to exercise pre IPO incentive stock options has serious implications for financial and tax planning, and it's technically a higher-risk, higher-reward situation. 

Now, assuming we're talking about ISOs issued in public companies, and examples where you're talking about much larger numbers, you don't technically have to spend your own money to buy the shares, and this is where things breach 3D chess-level complicated. So I did the responsible thing and I punted this one to Scott and James to explain. 

Scott and James: So when you have an incentive stock option, you're given the option to buy your stock at a predetermined price, but you have to buy it. And so the question is, how do I go about buying that? You have to either come to them with cash, which could be quite a bit of cash. That's okay, where do I get this cash from? Or you could use your options themselves to buy your options. So in other words, if I have 100 ISOs that vested, and I need to come to the table to buy them, well, can I sell a portion of those 100? Can I maybe sell 10 of my ISOs, for example, to free up cash to exercise the remaining 90?

The other thing is companies that do have ISOs, not always, but sometimes they also have RSU programs in conjunction with that. And sometimes your RSUs will vest on the same date that you have the option of purchasing your ISOs. So what some people do is, “Okay, my RSUs vest, I'm gonna sell them right away. That provides cash. I'm gonna use that cash to exercise my ISOs.” And when you do that, and we'll get into this later, I'm sure, but you don't pay income taxes upon exercising. 

Katie: How are ISOs taxed? The short answer is, it depends. If you did what we just described, you flipped those suckers right away, you'd pay ordinary income tax on your profits. So the profits being the difference between your strike price and the price you sold for on the stock market, known as the fair market value. In order to receive the more favorable tax treatment and have your profits be treated as capital gains, you would have to hold on for another year, and technically two years from the grant date. For example, 'cause I know that we're throwing a lot of dates at you, let's say you're granted ISOs on March 1, 2023, and you exercise your option and buy the shares on March 1, 2024. You would have to wait to sell until March 1, 2025 to receive capital gains treatment.

So what's the issue with this? Well, it introduces 12 more months of risk. 'Cause when you exercise your options and you pay the strike price, the fair market value of the stock on the stock market might be higher. So ta-da! Profit. But there's no guarantee it'll still be higher 12 months from now. Think back to if my Meta RSUs had been ISOs, and I had held onto them. As a sidebar, so you feel up to speed on the jargon, the profit that I'm referring to is technically called the “spread” or the “bargain element,” because someone decided that we did not have enough bullshit terms to remember already. The point is, if you want your profit or spread or bargain element to receive favorable tax treatment, you have to hold it for longer before selling.

This is, in some ways, no different than regular rules around selling stock. You have to hold for a year if you're gonna get long-term capital gains treatment, right? Now, if you're a high-roller exercising hundreds of thousands of dollars in income and ISOs, you may be faced with the alternative minimum tax. But I would say that is more of an edge case, because it really only applies to people who already have decently high incomes and very high options rewards. 

Scott and James: So what happens is, with AMT (alternative minimum tax), they basically, you run your tax bill two ways: the traditional way and then this alternative way, and the alternative way with ISOs, especially if there's a big bargain element, so the price between your exercise price and the current fair market value, the moment you start with the ISO exercise, that's what's added in to your tax bill. And then you have to pay taxes on that amount, on the AMT side of the things. Now you'll get that back as a credit in the future, but it could potentially take years to get that money back because of the way the tax code works. 

Katie: Unlike RSUs, ISOs are not taxed when they're granted, vested, or exercised, aka purchased; they're taxed when your shares are sold. For example, let's indulge in a jargon-filled run-on sentence. If you are granted ISOs and then they vest, and then you exercise them, then three years later you sell your shares and pocket the spread between your strike price and the fair market value, you pay long-term capital gains taxes on that profit. Human translation: If your company gives you the option to buy company stock at some point in the future at a specific price, and you do that, then a few years later, when the stock is higher, you sell it to some other schmuck, you pay capital gains taxes on your profit. To summarize, I ask Scott and James to outline the best and worst ISO scenarios so you can get a sense for both ends of the spectrum. 

Scott and James: The worst-case scenario is you do all of this, you pay the AMT tax bill, or maybe you're waiting to sell the shares to pay the AMT tax bill, and then the shares plummet, and then you go to sell the shares and you don't even have enough money to cover the tax bill. I had clients that saw this; Scott, I know you had clients that saw this, but if you were in companies—not to pick on these companies, but like a Coinbase or Zoom or Snap or Robinhood or Peloton, I don't know that all those offer ISOs, but all of them had stock prices that fell by 80% to 90% or more. So if you're looking at this and saying, oh, I've got this great ISO package here. I'm gonna exercise, which means I buy the shares, I'm subjecting myself to that alternative minimum tax, so I'm gonna have a tax liability due because of this, but I'm gonna be smart and hold onto these for 12 months so that when I do sell after exercising, I pay taxes at a lower tax bracket. So you do that thinking it's a good tax decision, and if everything goes up, it is a good tax decision. But if things plummet, well, now you're sitting here the following year with a tax bill and you're like, I don't even have that much in my accounting. My shares aren't even worth that much. And it actually...not only did it not benefit you, but it ended up costing you money to exercise your ISO. So that's a very real risk. 

The best-case scenario isn't just that the stock goes up, but it’s that it goes up more than the market. You know, if your stock's going up, you know, you exercise and your stock increases by 10%, that's good, but if the rest of the market went up by 20%, you still would've been better by selling, diversifying, and capturing the rest of the market. So best-case is holding onto those shares for at least a year after they've been exercised for the best possible tax treatment. And then also, best case is, did your stock outperform the market? Which is something that's impossible to predict ahead of time, because everyone thinks their company's gonna outperform the market ahead of time. But the reality is most companies don't. 

Katie: If you're dealing with ISOs and you've got questions for a professional, Scott and James had a few words of wisdom for who to seek out, depending on what you wanna know. 

Scott and James: I would say, if the question is just around what's the tax implications of this and that's it, a CPA is gonna be able to do that, because a CPA will help you model out what is your potential alternative minimum tax liability, what should we do in terms of, do we have a budget for how much we exercise this year to keep things under certain thresholds? So if that's it, a CPA is probably good to work with once you start dealing with ISOs and other forms of stock compensation, because it can very quickly become overwhelming, and then a mistake becomes very costly. And even if you don't make a mistake, you're always worrying about, did I do that right? Did I miss something? And just kinda have that there. 

If your bigger concern isn't just, okay, how do I get taxed on this? It's, how do I best utilize this in the pursuit of the things that I actually wanna accomplish? 

I think one thing Scott and I, when we talk on our podcast, it's never about the money. It's never about the portfolio. I think commonly we think of, oh, better finances means growing my portfolio, growing my 401(k), growing my savings. Well, to what end? You know, it's all about, how do we use that for what's actually most important? And so if you want help understanding, one, how do I prioritize, how do I set, we call 'em goals, values, whatever you want to call 'em. But how do you set kind of intention for what you want life to look like? Then, how do you understand whether it's the tax implications or what you should do from an investment perspective, or how you should coordinate this with cashflow? How does it really all come together to turn some of the success you're having maybe financially into that peace of mind of knowing that you're on track for what actually matters most? That's what a CFP or financial planner is gonna be better suited for, where it's not just super myopic on the taxes, but looking at the big picture to see how to do things. 

Katie: All right, y'all, that is all for this week. I hope it was enough jargon for you. I will see you next week, same time, same place, on The Money with Katie Show. Our show is a production of Morning Brew and is produced by Henah Velez and me, Katie Gatti Tassin, with our audio engineering and sound design from Nick Torres. Devin Emery is our chief content officer, and additional fact checking comes from Kate Brandt.