Understanding Your Options: RSUs, ISOs, and Your Financial Strategy

Many successful publicly traded companies include some form of stock options—sometimes called equity compensation—as part of their compensation and incentive package offered to executives and other employees. At its simplest, the purpose of equity compensation is to provide valued employees with a direct financial incentive to help the company thrive by making them part-owners—i.e., giving them equity. You can even observe a form of this incentivization by visiting your local Walmart: eligible employees are able to purchase company stock via payroll deduction, and there is usually a sign posted prominently outside the break room with the daily stock price on it. The message is clear: “Your efforts here have an impact on this number!”

Another benefit of equity compensation that is often used by companies in the startup or growth phase is its ability to compensate valued team members without using cash. The idea is that as the company grows, the value of the equity compensation also grows, benefitting both the employee and the firm.

Equity compensation can come in several forms, usually as different types of stock options. Rather than representing actual shares of stock, options represent the ability to own or control shares at a certain price. Most stock options come in one of two forms: restricted stock units (RSUs), or incentive stock options (ISOs).

When you receive RSUs, you are granted a specific number of company shares according to a vesting schedule. In other words, you cannot sell or transfer these shares until they have vested, which may happen over a period of time or when certain performance goals or milestones have been achieved. Suppose, for example, that you work for an incorporated company and you are granted 1,000 RSUs as part of your compensation package. Next, suppose your RSUs have a four-year vesting schedule, meaning that 25% of the shares vest each year. At the end of year one, you would have 250 vested shares, and at the end of year two, you would have 500 vested shares, and so on.

As already mentioned, RSUs are intended to align your interests with the company’s stock price and also to incentivize retention: it is to your advantage to stay with the company at least until your RSUs are fully vested. Meanwhile, as the stock price rises, the value of your RSUs increases.

Keep in mind, however, that the greatest benefit of RSUs can also be their greatest liability: their value is tied to the company’s stock price. In fact, because many companies offer additional RSUs over time as employees achieve longevity or rise up through the ranks, RSUs can also expose you to concentrated risk. After all, if a significant portion of your net worth is tied up in RSUs, a decline in the company’s stock price could have a substantial impact on your financial wellbeing.

The other common type of stocks options—incentive stock options or ISOs—give you the option to purchase company stock at a predetermined price, known as the “strike price.” ISOs may also provide potential tax benefits, based on the length of time you hold them. If you hold ISOs for at least one year after exercising them to purchase the stock and at least two years after the date they are granted to you, the difference between the strike price and the stock’s market value at the time of exercise is taxed as long-term capital gains, a rate that is usually lower than your ordinary income rate.

In other words, suppose you have ISOs with a strike price of $25 per share that were granted to you two years ago. The stock is currently trading at $50 per share, and you decide to exercise your option to purchase. If you then hold the shares for the required period of at least one year before selling, any appreciation in the stock’s value above your cost of $25 per share will be taxed at the more favorable long-term capital gains rate when you eventually sell the shares.

While ISOs offer potential tax advantages, they, like RSUs, also come with risks. If the company’s stock price falls below the strike price, your options may become worthless. Moreover, exercising ISOs often requires a cash outlay to purchase the shares, which can be a significant financial commitment. And, also like RSUs, you may find that over time, a large percentage of your net worth consists of a concentrated position in the company’s stock or related stock options.

Here are some ideas for managing your financial risk and tax liability related to stock options.

1. Diversification: It’s important to diversify your investment portfolio to mitigate the risk inherent in a concentrated position. You may want to think about selling a portion of your vested RSUs or stock acquired by exercising ISOs and reinvesting the proceeds into a diversified mix of assets.
2. Tax Planning: Timing matters here. A fiduciary financial advisor can work with your tax expert to coordinate the purchase and sale of stock or vested RSUs for maximized tax efficiency.
3. Risk Management: Certain hedging strategies or alternative investments may provide protection against the risks associated with concentrated positions.

While RSUs and ISOs can be powerful wealth-building tools, they also have particular risks that must be considered. A professional, fiduciary financial advisor can work with you to make sure you understand these tools and to incorporate them strategically into your overall financial plan in order to achieve your long-term financial goals.

As a fiduciary financial planner and advisor, Aspen Wealth Management can provide you with the guidance you need to navigate the complexities of concentrated wealth. We tailor our recommendations to your specific situation, whether that means diversifying your portfolio, optimizing your tax strategy, implementing risk management techniques, or developing a plan for unwinding a concentrated position. Visit our website to read our recent article, “Tax Tips for Year-End, 2023.”