In my Rich Habits research, there were four groups of self-made millionaires: Saver-Investors, Big Company Climbers, Virtuosos and Dreamer-Entrepreneurs.
Each group built their wealth very differently.
For the Big Company Climbers, between 70-80% of their wealth was generated through the receipt of Stock Compensation from their employer.
What types of Stock Compensation did these Big Company Climbers receive?
Typically, there were four types of Stock Compensation that made their wealth possible:
- Incentive Stock Options (ISOs)
- Restricted Stock Units (RSUs)
- Stock Appreciation Rights (SARs)
- Stock Grants
Incentive Stock Options (ISOs)
ISOs give an employee the right to purchase the company’s stock (called “exercising” the stock option) at a fixed price (called the “exercise price”), for a period of time not to exceed ten years from the date the options are granted to the employee (called “grant date”). The employee can only exercise the ISO as long as they are an employee of the company or within twelve months after termination of employment. There is no taxation to the employee when they receive their ISOs. Even better, there is no regular income tax when the employee exercises the stock option (buys the stock). Taxation occurs in two instances:
- When the employee exercises the stock option (purchases the stock) there is no regular income taxation, but there may be an alternative minimum tax on the excess of the fair market value of the stock on the exercise date over the employee’s exercise price (discounted purchase price of the stock).
- When the employee exercises the stock option (purchases the stock) and subsequently sells the stock there is taxation. Here is where ISO taxation gets complicated. When you buy your company stock (exercise the stock option) and sell the company stock, the taxable amount is determined based on when you sold the stock. You can purchase the company stock (exercise the ISO) and sell the stock in the same year (called a disqualified disposition) or you can purchase the company stock and sell the stock in a subsequent year. When you sell the company stock in a subsequent year the regular tax treatment depends upon how long you held the stock and how long you held the stock options.
When you Buy and Sell the company stock in same year, or within twelve months, you may have both W-2 Compensation and short term capital gain income.
Employers will grant ISOs to employees but place certain restrictions on an employee’s ability to exercise the ISOs. This is done, in part, to provide a means of preventing employees from seeking employment elsewhere. Employers use “vesting” as an anchor to keep employees. ISOs are typically granted annually and may be tied to some specific goal achieved by the employee or an overall goal (i.e. earnings target) achieved by the company.
Restricted Stock Units (RSUs)
RSUs are stock grants to employees which are restricted, typically via a time-based vesting schedule of between 3 – 5 years.
When an employee vests in an RSU, the fair market value of the vested stock is treated as W-2 Compensation to the employee. To pay the payroll taxes on that W-2 Compensation, the employee typically surrenders some of the RSU shares to the employer. The employer then liquidates those shares and uses the proceeds to pay the employee’s payroll taxes.
Stock Appreciation Rights (SARs)
SARs are not shares of stock, but Units that vest with the employee over time. The SARs Units are Granted to an employee at a set price, with a set Expiration Date, in which the employee may exercise vested SARs. When an employee exercises any vested SARs, the cash the employee receives is treated as W-2 Compensation.
Certain classes of employees, typically senior management, received outright Stock Grants. These were grants of stock in the employer company, issued to senior executives, without any strings attached, as part of their bonus compensation.
Tom Corley is an accountant, financial planner and author of “Rich Kids: How to Raise Our Children to Be Happy and Successful in Life”, “Effort-Less Wealth”, “Change Your Habits Change Your Life”, “Rich Habits Poor Habits” and “Rich Habits: The Daily Success Habits of Wealthy Individuals.”