Take control of your financial future by navigating these three common stock option pitfalls
By Taylor Maks, CFP® and Wealth Advisor
All those long hours and hard work has paid off and you have an opportunity to earn “Equity Compensation”. Just like a dog chasing a car you may not have a plan for when you finally catch what you were chasing. The uncertainty and unknown of the stock options or restrictive stock options (RSUs) could result in unforeseen bills, stress and missed opportunities for the financial freedom you’re pursuing. However, getting the most out of equity compensation can be done.
Decisions around equity compensation are complex and extremely personal and speaking with a wealth advisor that has a fiduciary responsibility to work in your best interest is a great way to achieve some confidence and ultimately align your decisions with your short- & long-term strategy.
Here’s 3 scenarios with common pitfalls & lessons to consider when navigating equity compensation:
#1: Understand the Tax Implications
Several years ago, Brian accepted a senior management position with a financial technology firm. The compensation package was generous, with a competitive base salary and RSUs on a two-year cliff vesting schedule.
When his 10,000 RSUs vested at $20 a share in January, Brian sold immediately and netted $200,000. He and his wife used the money to pay for their long-planned kitchen renovation and other home upgrades.
Pitfall: “Yes”- Brian’s company withheld taxes (including federal, state, local, social security and Medicare taxes), but they applied the minimum 22% withholding rate, which is a common practice.
Brian was not aware of this difference and his marginal tax bracket is 37% not 22%. The result of the oversight was Brian was hit with not only with a substantial tax bill but an underpayment penalty when he filed his tax return.
Lesson: RSUs are taxed as income as they vest and as capital gains when sold.
Should Brian have sold his shares as soon as they vested, or should he have waited? The answer is “it depends.” Brian paid a higher short-term capital gain rate since he sold them as soon as they vested. It may make sense to hold the RSUs for one year and one day and then sell them so you will be taxed at the more favorable long-term capital gains tax rate.
Think of RSUs as non-cash compensation, compared to stock options which are the opportunity to buy shares of company stock at the strike price for a certain period of time. Incentive stock options (ISOs) and non-qualified stock options (NSO) are taxed differently than RSUs. Stock options are taxed on the profit when you exercise them. ISOs are also subject to Alternative Minimum Tax (AMT).
What is most important to recognize is that any stock event comes with tax implications that you need to plan for by talking with your tax professional.
#2: Understand the Risk of Having Much of Your Portfolio Invested in Company Stock
Thomas’s compensation for a major hotel chain includes a base salary and RSUs. Thomas doesn’t want to pay income tax on the earnings, so he reinvests the shares. Thomas also tends to put his finances on auto-pilot and rarely, if ever, looks at his overall portfolio asset allocation. He is now close to retirement with an investment portfolio that is heavily weighted in his company’s stock.
The pandemic hit the hospitality industry hard, and Thomas lost his job. When the stock price plunged double-digits, he also lost a chunk of the assets he was counting on for retirement.
Pitfall: Too much of Thomas’s net worth was tied to his employer. If you believe in your company and the stock increases in value, the upside is great. However, the potential downside is risky.
Lesson: But that doesn’t mean that it’s always a poor decision to be overexposed to company stock. Lots of factors come into play: How secure is your job? What is your net worth? Do you a have a high-earning spouse in a totally different industry? What’s your risk appetite?
There’s no hard and fast rule as to how much company stock to hold in your portfolio. But it is important to periodically look at whether or not the current allocation of company stock in your portfolio is appropriate for your life stage and financial goals.
For instance, based on your financial plan, it can be advantageous to sell company stock and use that money to indirectly fund contributions to a tax-deferred account such as a 401(k) or health savings account.
#3: Negotiate Your Equity Compensation
Amy’s skills as a data scientist are in high demand, and she was in the enviable position of choosing between two lucrative job offers. One offer was from a well-established public company and the other was from a tech start-up. The salary from the well-established firm was $25,000 higher than the offer from the start-up, but the start-up offered Amy non-restricted stock (NSO) options.
Pitfall: The stock package seemed complicated, so Amy went to work with the firm that offered salary only since she felt it was less risky.
In this case you guessed it: the start-up hit the big time and Amy’s stock options would have been worth well more than $25,000.
Amy failed to consider the value of NSOs as she evaluated which company to join. Her mistake wasn’t necessarily that she chose the job without NSOs, but that Amy did not fully understand what she was passing up.
Amy also didn’t realize that just like base salary or paid time off, stock options are negotiable. Especially as you move into higher paying positions, companies prefer to align more of your total compensation directly to how well the company performs. While an employer may not grant Amy’s request for an additional $30,000 in base salary, they may be open to offering stock options rather than cash.
Lesson: Sometimes it’s wise to accept less salary for equity. Other times, another type of compensation is more lucrative and will move you closer to your financial goals.
If Amy did accept the job offer with the NSO, she would be wise to be more conservative with her budget. If the market price for the stock drops, so will your total compensation. I’d rather see clients like Amy be surprised (and happy) if the stock goes up rather than having to tap into other assets if the stock goes down because they were counting on selling RSUs for $20 a share and now they are at $10 a share.
Look at the Big Picture
So, what could Brian, Thomas, and Amy done differently to maximize the impact on their overall financial plan? I can’t say with certainty because equity compensation doesn’t exist in a vacuum. It may make sense for one client without an immediate liquidity need to wait to exercise their stock options, yet another should sell their RSUs to invest in a first home. Yet another client should sell and invest the proceeds into a more diversified 401(k).
While no one wants to get a surprise tax bill and penalty like Brian, don’t be like Thomas and base your decision to exercise options on taxes alone. A conversation with her financial advisor could have helped Amy weight risks with rewards and perhaps negotiate a better offer.
Don’t lose sight of the forest for the trees. Focus on the bigger picture: how will my decision impact my financial goals? How does keeping or selling stocks impact my overall risk profile and exposure?
Stocks are just one piece of your unique financial puzzle, but you can maximize their effectiveness.
Your financial advisor can give you the tools you need make the best decisions on equity compensation and allow you to take a more strategic approach to incorporating this compensation into your overall financial plan.
The individuals and situations depicted here are hypothetical only, and do not represent the actual performance of any particular investments or strategy. All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful.
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This article is not intended to provide specific legal, tax, or other professional advice. For a comprehensive review of your personal situation, always consult with a tax or legal advisor.