Focus on executive compensation:
What you need to know about equity plans
Vanguard Asset Management Services™
Companies offer equity compensation for many reasons—to attract and retain employees, to build equity and
employee loyalty, and to preserve cash. If you’re offered equity compensation, you should familiarize yourself
with how the plan works.
How stock options and restricted stock are taxed
Nonqualified stock options (NQSOs) are generally taxed upon exercise. The “spread”—the difference
between the exercise price and the market value of the stock on the date of exercise—is taxed as ordinary
income and subject to payroll taxes. When the stock is sold, any appreciation or depreciation from the date of
exercise is determined by subtracting the tax basis (exercise price plus the spread) from the sale price. The
difference is subject to capital gains taxes.
Incentive stock options (ISOs) are generally taxed when the stock is sold, not when it’s exercised. Upon
exercise, no tax is due, although the spread is included as income for purposes of the Alternative Minimum
Tax (AMT) upon exercise. At sale, the stock receives capital gains tax treatment if it’s held more than one
year from the date of exercise and the sale date is at least two years after the option was granted. ISOs are
considered “disqualified” if they don’t meet these two rules. The tax treatment for disqualified ISOs is the
same as for NQSOs.
Restricted stock shares are generally taxed at vesting and are included in your W-2 as wages subject to
payroll taxes. When the stock is sold, capital gains taxes are due on any appreciation/depreciation from
the vesting price.
How do the tax consequences compare?
For restricted stock, no decision needs to be made on when to exercise; upon vesting, the shares are yours
and immediately taxable. For ISOs and NQSOs, you’ll need to decide when to exercise the shares, as the
following example shows. Let’s assume you’re offered the right to buy 1,000 shares with an exercise price of
$10 per share, and you have an ordinary income tax rate of 28% and a long-term capital gains tax rate of 15%.
Taxes for ISOs
Taxes for NQSOs
If you exercise the options
when market value is $20
per share
Generally, no taxes due*
($20 – $10) x 1,000 x (0.28) = $2,800
If you sell at $30 per share
after holding for more than
a year
($30 – $10) x 1,000 x (0.15) = $3,000
($30 – $20) x 1,000 x (0.15) = $1,500
Total tax due
$3,000
$4,300
*The AMT may apply.
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Factors to consider before exercising your options
Should you exercise and sell all of your options? Just a portion of them? Or, should you wait? It’s all about
weighing risk based on your personal situation. Consider the following factors:
•Your company’s plans and provisions. It’s important to know the details of your firm’s plan before you
decide when to exercise or buy the stock.
•Your company’s growth potential. If the outlook for your company is good, you may not want to immediately
exercise the options. Historically, stocks increase in value over time, so by waiting you’ll enjoy upside leverage
without any cash investment. In contrast, if your company’s stock is volatile, making the price swings
personally hard to tolerate, you may want to consider reducing your company stock with tax efficiency in mind.
•The diversification of your overall portfolio. If the stock options represent a large portion of your net worth,
you may wish to lower your risk by diversifying your overall portfolio. Be wary of being too heavily weighted in
any single stock.
•Your financial needs and goals. Your decision to sell shouldn’t be based purely on your need for cash. You
should also consider your proximity to the option expiration date, the stock’s current value versus expected
future value and, for ISOs, the required holding periods for getting taxed at capital gains rates rather than your
ordinary income tax rate.
•Market conditions. If you expect the stock to continue to rise, you may wish to hold on to it longer to take
advantage of future gains. Keep in mind that unlike marketable options, you can’t sell employee stock options
directly in the open market.
•Income tax implications. Taxation can’t be avoided, but it can be managed. In the case of NQSOs, you may
want to consider exercising your options over a few years—rather than all at once—to avoid being forced into
a higher tax bracket. An ISO spread at exercise is considered a preferential item for purposes of the AMT,
which may increase your potential tax liability, so AMT planning is critical to optimize your tax situation.
•Estate tax implications. If your company’s NQSOs are transferable to family members, you may be able to
trim your estate tax by giving options to your heirs.
Redemption and taxation of stock options can be complicated, so it’s important to consult a financial or tax
advisor to determine your best execution plan. Careful planning and professional assistance will help you make
better decisions and reduce costly mistakes.
Talk to your Vanguard representative
If you’d like to discuss this topic further, contact your Vanguard Asset Management Services financial
advisor or your Vanguard representative. Due to the complexity of stock options, we highly recommend
that you discuss your personal situation with a financial or tax advisor.
Vanguard Asset Management Services are provided by Vanguard National Trust Company, which is a federally chartered, limited-purpose trust company operated under the
supervision of the Office of the Comptroller of the Currency.
The information provided here is for educational purposes only and is subject to change. It is not intended to be construed as legal or tax advice. Consult an estate planning
attorney or a tax advisor about your individual situation.
© 2012 The Vanguard Group, Inc. All rights reserved.
1SEB 042012