scorecardresearch

ESOPs: Preparing for the year-end bounty

If your employer is planning to grant you employee stock ownership plans, or ESOPs, along with your regular bonus, increment or promotion, this is a good time to understand this complex incentive.

If your employer is planning to grant you employee stock ownership plans, or ESOPs, this year, along with your regular bonus, increment or promotion, this is a good time to understand this complex incentive. You must have a financial plan in place to make the best of this bonanza.

Deconstructing ESOPs
The trend of awarding ESOPs was started by the information technology industry. "Many sectors today, including financial services, retail and consumer products companies, are extending this benefit," says Homi Mistry, partner, Deloitte Haskins & Sells. But why ESOPs? "This is primarily an employee retention tool," says Anil Rego, CEO, Right Horizons. It is important to understand the nitty-gritty as unlike a bonus, the tax treatment for ESOPs is complicated. It is only after the vesting period - decided by your employer Deconstructing ESOPs The trend of awarding ESOPs was started by the information technology industry. "Many sectors today, including financial services, retail and consumer products companies, are extending this benefit," says Homi Mistry, partner, Deloitte Haskins & Sells. But why ESOPs?

"This is primarily an employee retention tool," says Anil Rego, CEO, Right Horizons. It is important to understand the nitty-gritty as unlike a bonus, the tax treatment for ESOPs is complicated. It is only after the vesting period - decided by your employer - that you can exercise your option to buy the shares of the company you work for. The price you have to pay is generally lower than the prevailing market rate. "In fact, the vesting is done in such a way that the exercise is staggered over three to five years. The idea is to ensure that the employee is tied to the company for a longer time," says Rego. An employee typically buys the shares only if the market price is higher than the exercise price.

Tax on ESOPs is paid on the difference between the fair market value of the stock (the average of the opening price and the closing price on the day the option is exercised) and the price at which the option was granted. "This amount is treated as a perquisite and taxed from the employee," says Mistry. You also pay 15 per cent short-term capital gains tax if you sell these shares within one year from the date of allotment. There is, of course, no long-term capital gains tax, as in the case of other equity transactions. "Typically, ESOPs over the long haul could prove to be a sure way of enhancing your net worth," says Rego.

But financial planners say the tax liability can be an undue drain on finances, especially if the amount is large. For instance, (See How ESOPs are taxed) if the number of shares was 1,000 instead of 10, the tax liability could have crossed Rs 1.5 lakh. "Many times, this results in employees selling off their shares immediately to ensure that the adequate tax amount is available," says Mistry. However, you still have the option of selling a few shares and holding on to the rest.

Deployment avenues
The cash your stock options bring in could be a big lump sum. The temptation to spend it all will be hard to resist. But here is a word of caution. "Depending on the quantum of your windfall, you should try to invest at least 40 per cent of the amount," says Kartik Jhaveri, financial planner with Transcend Consulting.

Alternatively, if your contingency fund is running low, this may be a good time to replenish it. Financial experts say, at any given point, you should put aside an amount equal to about six months of your expenses in such a fund. You can either park this money in a bank fixed deposit or a short-term fixed maturity plan, since both offer shortterm maturity options. Earlier, a liquid fund would have been ideal, but lately these funds have been fetching very low returns of about 4.5 to 5.0 per cent.

Jhaveri suggests the money can also be used to fulfil any deployment which may be pending as per your financial plan. For instance, if you need to increase your equity allocation, this lump sum amount can be converted into a Systematic Transfer Plan, whereby money is transferred into an equity fund at the frequency you choose. This works like a Systematic Investment Plan and lowers the risk of investing all your funds in stocks at one go. Also, it may be worthwhile to prepay any expensive loans that you might be carrying. This could include your credit card outstandings that comes at an interest rate of up to 36 per cent or your personal loan on which you might be paying between 18 and 20 per cent. You could also consider prepaying your home loan. "If you have a good deal on interest rates and are saving tax through the loan, this may be given a miss. You may want to consider investing some of your windfall in some other asset class," says Rego. It could be a direct equity portfolio or a commodity fund. So, there are a number of options for you. Just wait for the good news to trickle in.

Courtesy: Money Today