With tax season upon us, it is important that you know everything that needs to be reported on your tax return. One topic that can be difficult to understand is stock compensation. There are a few types that are taxed in different ways, so it is important to know what type of stock compensation you are getting from your employer.
- Restricted Stock Units (RSUs)
RSUs are straightforward, in that they are taxed as ordinary income when they vest. The fair market value (FMV) at the time they vest is now your cost basis in the stock. This should show up on your W-2 and your employer should be withholding tax on your behalf. However, if you are in high tax brackets, your employer may not withhold enough automatically, and it will be your responsibility to pay additional tax to cover the difference. You would want to make a quarterly estimated payment at the time of vesting to avoid any withholding penalties. Any gain will then be taxed when you sell at capital gains rates.
- Non-Qualified Stock Options (NQSOs)
NQSOs are taxed similar to RSUs. At exercise, the difference between the market price and the strike price will be taxed as ordinary income, and the FMV will now be your cost basis. Any further gain will be taxed at short- or long-term capital gains rates depending on how long you hold the stock from that point on. The key difference between NQSOs and RSUs is control over when you exercise the stock options. Being able to time when you take the tax on these can be a powerful tool for tax planning.
Note that for both RSUs and NQSOs it is important to double check that you are reporting this correctly for your sake. These can often show up on 1099s with an inaccurate cost basis of zero or at the strike price. You already paid income tax; you don’t want to also pay additional capital gains tax and pay in twice. It is on the tax preparer to take the cost basis reported on the W-2 and adjust the cost basis reported on the 1099.
- Incentive Stock Options (ISOs)
ISOs are the next type and get a bit more complicated. They are not taxed at grant or when they are exercised. However, the difference between the FMV and the strike price can trigger Alternative Minimum Tax (AMT) in the year you exercise. You can, in certain situations, be required to pay tax before you even sell the stock. Otherwise, ISOs are taxed when you sell them. If you hold the shares for more than 1 year after exercise and more than 2 years after grant, the gains are taxed at long term capital gains tax. If you sell earlier than this, the gain can be taxed as ordinary income.
Stock compensation can be a great form of income apart from your standard salary. Please take the time to review the type of compensation you are receiving and understanding the tax implications involved. If you have any questions, it is always a good idea to reach out to your financial advisor or tax preparer to help guide you through the planning involved.