Employee Stock Ownership Plan (ESOP) is a great way for employees to build wealth over time. However, it’s important to understand when it is the right time to exercise your ESOPs.
In our ongoing series on ESOP, we’ve already covered the basics of ESOPs, taxation, benefits and drawbacks of ESOPs and how to decide whether you should invest in your company’s ESOP.
In this post, we will discuss a critical aspect of ESOPs: the ideal timing to exercise them. We’ll break it down into two scenarios – exercising ESOPs right after vesting and waiting for some time before exercising.
So, let’s dive in and help you make an informed decision!
Estimated read time: 3 minutes and 52 seconds
Buckle up. Here we go!
Exercising your ESOP right after vesting
Picture this – your ESOPs have just vested, and you can’t wait to become a shareholder of your company. Exercising right away might be an appealing option, and here’s why:
Benefits of exercising your ESOPs right after vesting
1. Potential gains
Exercising early allows you to grab the opportunity to own company shares immediately. If the company’s stock price soars in the future, you could enjoy significant gains on your investment.
Also, long-term capital gain taxes are lower compared to short-term capital gain taxes.
As you exercise your ESOPs, you will be holding shares of your company, which can add diversity to your investment portfolio. This diversification can be a smart move to mitigate risk, especially if your current investments are concentrated in a particular asset class.
3. Tax benefits
Exercising your ESOPs early offers a lot of tax advantages.
When you exercise your ESOPs, the difference between the fair market value (FMV) of the shares and the exercise price is considered a taxable perquisite. This means you will have to pay tax on this amount at the time of exercise.
If you are exercising your ESOPs earlier, the chances of the difference between the exercise price and FMV being lower is high. Therefore, you pay less tax. Read more about the tax on perquisite and ESOPs here.
Also, when you exercise earlier, the chances of holding the shares for more than one year (listed) are higher. And you might qualify for long-term capital gains tax, which is typically lower than short-term capital gains tax.
However, before you leap into action, consider the following potential downsides of exercising ESOPs right after vesting:
Disadvantages of exercising your ESOPs right after vesting
1. Market volatility
Stock prices can be highly volatile and subject to market fluctuations. Exercising your ESOPs early means you take the risk of the stock price dropping below your exercise price, leading to paper losses.
2. Cash flow constraints
Exercising ESOPs requires you to pay the exercise price and applicable taxes.
If you don’t have enough cash on hand, you might be forced to sell some shares immediately. You might miss out on potential future gains and again end up paying short-term capital gain tax on the sold shares.
Remember, if you work for an eligible startup with an IMB certificate, you have at least 5 years to pay tax on the perquisite income unless you either resign or sell the shares before that. More on this here.
Exercising your ESOP after some time
Now, let’s consider the alternative – waiting for some time before exercising your ESOPs. This option offers its own set of benefits:
Benefits of exercising your ESOPs after some time
1. Risk mitigation
By waiting, you can observe how the company performs before committing to exercise. If the company is thriving and showing strong growth, it might increase your confidence in investing in ESOPs.
2. Additional vesting
Waiting allows you to earn more ESOPs over time. This means more significant potential gains if the stock price rises in the future.
3. Financial planning
Delaying exercise gives you time to plan and save funds for exercising your options, reducing cash flow concerns.
Disadvantages of exercising your ESOPs after some time
1. Potential missed gains
If the company’s stock price experiences a meteoric rise, you might regret not exercising your ESOPs earlier, missing out on potential profits. As you don’t own the shares, you can’t sell them to realize the profits.
2. Tax implications
Tax on perquisite is based on your tax slab. So, if your company has done well, waiting for some time before exercising your ESOPs increases the chance of your prerequisite amount being higher and you paying higher taxes.
Also, exercising your ESOPs after a longer period might mean holding onto the shares for a shorter time before selling. This could attract higher short-term capital gains tax.
The right time to exercise your ESOP
When it comes to exercising your ESOPs, timing plays a vital role in determining your potential gains and tax implications.
Exercising early means you can capitalize on potential growth and enjoy potential tax advantages. However, it also involves market volatility and cash flow considerations.
On the other hand, waiting allows you to observe the company’s performance, earn more ESOPs, and plan your finances. But you might miss out on early gains and end up paying more taxes.
As always, there’s no one-size-fits-all answer.
Carefully assess your financial goals, risk tolerance, and individual circumstances before making a decision. If you’re unsure, consider seeking guidance from a financial advisor or tax professional to help you navigate this critical aspect of your ESOP journey.
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