A stock option plan is a wealth creation plan that essentially gives an employee the option to buy a certain amount of company shares either at market value or at a discounted price. Employees, therefore, become shareholders of the company. As per the stipulated time frame defined in their stock option scheme document, employees can actually buy the shares that were once provided to them as an option. Post this, they can either monetize all or some of these shares when the company announces a liquidity event like a buyback or secondary sale or an IPO (Initial Public Offering).
Click here for a blog on liquidity events in a startup.
But employees should know that the wealth generation process through stock options might be a long one and given that liquidity events do not take place very often or with a set periodicity. The other factor that could hinder is the tax implications on the exercise and sale of stock options. But there are some ways in which the tax burden can be neutralized – rolling granted stock options into one’s Individual Retirement Accounts (IRA) is one such mechanism.
Let’s look at how this can be done and the benefits.
What is an Individual Retirement Account (IRA)?
An IRA is an account set up at a financial institution that allows an individual to save for retirement with tax-free growth or on a tax-deferred basis. There are 3 main types of IRAs, and each has different advantages:
A traditional IRA (individual retirement account) allows individuals to direct pre-tax income toward investments that can grow tax-deferred. The Internal Revenue Service (IRS) assesses no capital gains or dividend income taxes until the beneficiary makes a withdrawal.
Roth IRA is a special retirement account where you pay taxes on money going into your account, and then all future withdrawals are tax-free. Roth IRAs are best when you think your taxes will be higher in retirement than they are right now. However, you can’t contribute to Roth IRA if you are a high-earner
A Rollover IRA is an account that allows you to move funds from your old employer-sponsored retirement plan into an IRA. With an IRA rollover, you can preserve the tax-deferred status of your retirement assets without paying current taxes or early withdrawal penalties at the time of transfer
When you choose an IRA, the tax benefits allow your savings to grow potentially, or compound, more quickly than in a taxable account.
Advantages of investing:
- Supplement your current savings in your employer-sponsored retirement plan
- Gain access to a potentially wider range of investment choices
- Take advantage of potential tax-deferred or tax-free growth
Stock Options in an IRA
Employees pay no tax on stock allocated to their ESOP accounts until they receive distributions, at which time they are taxed on the distributions. If the employee is younger than age 59½ (or age 55, if they have terminated employment), they are subject not only to applicable taxes but also to an additional 10% excise tax unless they roll the money over or transfer it into an IRA or a successor plan in another company. The exception here is if the employment was terminated due to death or disability.
If the money is rolled over into an IRA or successor plan, the employee pays no tax until the money is withdrawn, at which point it is taxed as ordinary income. Rollovers from stock option distributions to IRAs are available for distributions of stock or cash over periods of less than 10 years.
When dividends are directly paid to participants on the stock allocated to their stock option accounts, such dividends are fully taxable, although they are exempt from income tax withholding and are not subject to the excise tax that applies to early distributions.
Disclaimer: This article has been prepared for general guidance on the subject matter and does not constitute professional advice. The matters described herein are general in nature and have not been evaluated based on applicable laws. You should not act upon the information contained in this note without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this note. LetsVenture Technologies Private Limited, its partners, employees, and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. Without prior permission of LetsVenture Technologies Private Limited, this note may not be quoted in whole or in part or otherwise referred to any person or in any documents.
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