Equity plans that provide opportunities for employees to obtain company stock are popular benefits. About 72 percent of U.S. companies offer some form of equity compensation to certain employees, according to a 2023 Morgan Stanley survey. There are two types of equity compensation: Employee Stock Purchase Plans (ESPPs) and Stock Options. ESPPs allow employees to buy company stock at a set price, often at a discount, through automatic payroll deductions over a specified period. Stock options are often granted as part of bonus programs, not requiring the employee to sign up.
ESPPs typically allow employees to buy shares at a discount, which can result in immediate gains if the stock price appreciates. In 2024, the average discount offered by ESPPs is around 15 percent, with some plans offering up to 20 percent. Employees typically must opt in for this program.
Types of Stock Options
Here are some common types of stock options and key points to consider:
- Incentive Stock Options (ISOs): These are reserved for employees and offer potential tax advantages, as they are taxed as capital gains at a lower rate than ordinary income. In 2024, the IRS continues to favor ISOs with favorable tax treatment, provided certain holding period requirements are met.
- Non-Qualified Stock Options (NSOs): These are more flexible, with fewer restrictions, and can be granted to employees, board members, and contractors. NSOs are taxed as ordinary income when exercised.
- Restricted Stock Units (RSUs): RSUs are company shares given as part of compensation but come with vesting restrictions. Employees do not own the stock or have shareholder rights until vesting conditions are met. RSUs are taxed as ordinary income upon vesting.
- Stock Appreciation Rights (SARs): SARs provide employees with the right to receive the increase in the value of a specified number of shares over a set period. Employees do not purchase the stock but receive the difference in cash or additional shares. Tax implications for SARs are like NSOs.
Pros of Stock Option Plans
- Potential for Increased Net Worth: Some sources state that employees holding these shares for at least a year may realize returns up to 30 percent higher than their initial investment due to favorable tax treatments and long-term capital gains.
- Supplementing Cash Flow: Selling ESPP shares upon vesting can generate extra income to be used to pay down debt or invest in other opportunities.
Cons of Stock Option Plans
- Investment Risk: Holding a significant portion of your investments in company stock can be risky. According to a 2024 report by Morningstar, employees with more than 50 percent of their portfolio in company stock face greater financial risks, especially in volatile markets.
- Concentration Risk: A large portion of your net worth tied up in company stock could be detrimental if the company faces difficulties. Remember both your salary/income and the equity are reliant on the success of the company. For instance, recent market fluctuations have highlighted the risks of over-concentration in a single stock.
Mitigating Risks
To manage these risks, diversification is crucial. If a large portion of your portfolio consists of company stock, consider gradually selling some shares to invest in a variety of asset classes. The Financial Industry Regulatory Authority (FINRA) recommends maintaining no more than 10-15 percent of your portfolio in company stock to avoid over-concentration.
Also, be aware of the tax implications. Selling shares too soon might lead to higher short-term capital gains taxes, while holding them longer could qualify you for lower long-term capital gains rates. In 2024, the long-term capital gains tax rate remains at 15 percent for most taxpayers, which can be a significant advantage for those who hold their ESPP shares longer.
Acquiring company stock can be a valuable tool for building wealth and achieving financial goals. To maximize its benefits, regularly review your participation and adjust as necessary. Consulting a financial advisor can also help you navigate these complexities and balance growth opportunities with risk management.
Read more Aspyre Insights about managing bonuses and other performance-related compensation.