Stock options give you the right to buy your company's shares sometime in the future at a preset price. If the stock price rises, you're a winner. For example, suppose your company gives you the right to buy 1,000 shares at $10 a share. If the stock is worth $50 a share when you exercise your option, your pretax profit is $40,000. But if the stock price falls below $10 a share, the options are worthless.
Restricted stock costs you nothing as long as you meet the vesting requirements. That usually means you have to stay on the job for a few years. But once the stock is vested, it's yours. Even if the price has fallen since the stock grant, it's still worth something. Suppose your company gives you 1,000 shares of restricted stock worth $50 at the time of the grant. When the stock vests, it's worth just $10. You still have a gain of $10,000.
Most companies award fewer shares of restricted stock than stock options. A company that previously gave workers 10,000 stock options would probably give them 3,000 to 4,000 shares of restricted stock, which limits your ability to profit from future gains, says Bruce Brumberg, editor of myStockOptions.com.
Stock options aren't usually taxed until you exercise them, which gives you some control over when you pay your taxes. Restricted shares are taxed in the year they vest, whether you sell them or not. The IRS considers the shares compensation, so you'll pay taxes at your ordinary income rate, not the lower capital gains rate, says Martin Nissenbaum, national director of personal income tax planning at Ernst & Young.
Most restricted stock vests in stages, Brumberg says, so you probably won't have to pay the entire tax bill in one year. For example, if you receive 4,000 shares of restricted stock, the stock may vest in increments of 25%, or 1,000 shares, a year.
Taxes are usually based on the market value of the shares when they vest, not the value at the
time of the grant. If your 1,000 shares of restricted stock are worth $30 a share when they vest, you'll pay income taxes on $30,000, even if the shares were worth much less at the time of the grant, says Gregory Merlino, financial planner with Ameriway Financial Services in Voorhees, N.J.
There is an alternative to paying taxes when your stock vests, but it's risky. You can make what's known as a Section 83(b) election, which requires you to pay taxes within 30 days of receiving the grant. You'll pay income tax based on the value of the stock at the time of the grant, and future gains will be taxed at the lower capital gains rate.
If the stock rises significantly between the time of the grant and vesting, an 83(b) election will produce a much lower tax bill. Some restricted stock programs don't allow this strategy.
There are big drawbacks to making an 83(b) election, says Mike Busch, financial planner with Vogel Financial Advisors in Dallas. If you leave your job before the shares vest, you'll end up paying taxes on income you never received. Similarly, if the shares decline in value, the IRS won't refund your overpayment.
Gains and dividends
• If your restricted stock pays dividends, you'll receive dividend payments, even if your shares haven't vested. The dividends are considered income, so you'll pay your ordinary income tax rate, not the lower 15% rate, Nissenbaum says. Once the stock vests, dividends will be taxed at the lower rate. If you make an 83(b) election, however, you'll pay the 15% rate on dividends right away.
• If you hold on to your restricted stock after it has vested, it's subject to regular capital gains treatment. As long as you wait at least a year to sell, you'll qualify for the 15% capital gains rate on any gains.
Sandra Block covers personal finance for USA TODAY. Her Your Money column appears Tuesdays. Click here for an index of Your Money columns. E-mail her at: firstname.lastname@example.org .