Receiving a grant of stock options or restricted stock units (RSUs) is a reason to celebrate. But now comes the tricky part: making the most of the equity comp opportunity, including financial and tax planning. Stock compensation is complex. It’s easy to make costly mistakes.
In two myStockOptions “advanced bootcamp” webinars this summer, leading experts in stock options and RSUs discussed equity comp blunders to avoid, among many other topics (Stock Option Exercise Strategies and Restricted Stock & RSU Financial Planning). This article covers five common mistakes as explained by these webinar panelists.
Mistake No. 1: Not Understanding Your Grant Or How It Works
This point may seem obvious, but you’d be surprised. Employees sometimes tell their financial advisors they have “stock options” but upon inspection of the plan documents it turns out they have another type of equity comp. So, first of all, confirm which type of equity grant you have.
A related mistake is simply failing to read all the stock plan documents and not fully understanding the terms of the grant. Study up on them. “Grant info needs to be organized, saved, and updated to provide ongoing guidance,” suggests Bill Dillhoefer, the CEO of Net Worth Strategies, the company behind the StockOpter financial-planning tool for stock options.
Crucially, understand that stock options have a set period during which they can be exercised after vesting. When the option term ends, unexercised stock options expire and are irrecoverable. Understand the timeframe of your stock options and steps you must follow so that you’re not caught in a scramble to exercise on the final day before expiration. You do not want to let valuable in-the-money stock options expire.
RSUs bring some different planning factors. “Roughly how much will each vested amount be worth, pre- and after-tax?” asks Meg Bartelt of Flow Financial Planning. As an advisor who works with clients at pre-IPO and newly public companies, she also considers the special traits of RSU grants made by private companies. With her clients, she evaluates whether simply working at the company for a specified length of time after the grant is enough for the shares to vest or whether the stock plan requires a second vesting trigger involving a liquidity event (i.e. IPO or acquisition by a public company).
Mistake No. 2: Not Understanding The Taxes Or Letting Taxes Drive Decisions
You need to understand the taxation of your grants before you do anything with them. The tax treatment is crucial for both avoiding IRS problems and making the most of your gains. At the same time, the financial advisors all caution, understanding the taxation doesn’t mean taxes should be the principal driver of decisions.
“While taxes are key factors, it’s dangerous to base decisions principally on tax aspects and neglect coordination with goals and investment risk,” warns David Marsh, a Financial Planning Case Manager at Ameriprise
AMP
In other words, “the tax tail should not wag the option dog,” says Megan Gorman of Chequers Financial Management. However, she acknowledges, “to build wealth, you have to deal with tax consequences.” So how do you get the balance right?
Model tax scenarios for your stock options and be prepared, Megan advises. For example, she points out that you should “be prepared for your company’s tax withholding to not be sufficient to cover your tax bill.” The IRS default flat withholding rate of 22% for supplemental wage income, such as the spread at option exercise or restricted stock unit (RSU) vesting, is often lower than your actual income-tax rate, she observes.
While the withholding rate jumps to 37% for supplemental wage income in excess of $1 million during the calendar year, employees between those extremes still need to pay the taxes not covered by the 22% default rate. The shortfall can be paid in quarterly estimated taxes based on the amount owed, among other methods.
Stock options aren’t the only equity awards with tricky taxes. Mistakes with the taxation of RSUs can also be very costly. “The worst-case scenario with RSUs, in my opinion, is that you lose money on them,” says Meg Bartelt. “And that’s a possibility if you do not sell enough RSUs immediately to cover your full tax bill.” The concern? The stock price could suddenly fall after vesting. “The bottom line is that if the stock price drops enough after the initial withholding of 22% before you sell more shares to pay your taxes, then the shares you still have can be worth less than the taxes you still owe.”
“Get ahead of the game by preparing a projected tax return to see the impact of vesting RSUs on your tax return,” advises Daniel Zajac, co-founder of Zajac Group. “Consider ways to defer other income and/or increase deductions to reduce the spike in your taxable income,” he adds. “For example, increase 401(k) contributions, participate in a nonqualified deferred compensation plan, make bigger charitable donations, or separately increase salary withholding.”
Lastly, watch your tax bracket. Stock compensation can push your income for the year into a higher bracket, leading to more taxes—something that careful timing of option exercises and RSU vestings can avoid. “The total picture of your grants is really important,” says Daniel Zajac. “I’ve seen clients create cash by exercising and selling nonqualified stock options when they’ve just had RSUs vest. That could needlessly push them into a higher tax bracket.”
Mistake No. 3: Forfeiting Your Grant In Job Termination
If you leave your company, the vesting of your stock options stops and the term usually ends early, requiring you to exercise the options soon after your departure to prevent forfeiture. These rules and timeframes can vary according to the reason you left work (e.g. job change, disability, death, retirement).
Chief among the option terms to know are the vesting provisions and what would happen upon job termination, which usually triggers a very short window for option exercise before the grant term expires. “It’s crucial to clarify equity awards’ terms for vesting and at separation of service,” says David Marsh of Ameriprise. “Realize they may not all be the same.”
As for restricted stock units, job termination stops the vesting of RSUs. So if you have a big vesting date coming up, you may want to stick around for it before any planned job change or retirement.
Other types of job terminations and life events may affect vesting differently. “How do leave of absence, disability, death, acquisition of your company, etc. affect the vesting schedule?” is something Chloé Moore, founder of Financial Staples, wants her clients to understand and communicate.
David Marsh lamented that many optionholders neglect to designate a beneficiary for vested stock options in case of death. “This is usually allowed in the plan, but often employees are unaware of that.” Also be sure that beneficiaries and executors of your estate know the option exercise deadlines.
Mistake No. 4: Not Having A Strategic Plan For The Shares
When you exercise stock options or when your RSUs vest, a big mistake is not having a plan ready to go for your newly acquired shares.
Overconcentration in your company’s stock is a major danger employees face with shares they get from equity awards. Loyalty to your company’s stock can work against you if too much of your wealth is tied up in the stock and the price then drops. “It’s amazing to me how many times clients who understand they have a lot of company stock lose track of how concentrated they are and how movements in the stock price and new grants affect that concentration,” says David Marsh. “That’s a particular blind spot,” he warns.
Indeed, it would be hard to find a financial advisor who doesn’t extoll the virtues of diversification. “Investments that are diversified—your money is invested a little bit in a lot of different stocks or bonds—perform better, on average, than investments that are concentrated in one stock,” points out Meg Bartelt.
She often advises clients with just-vested RSU shares to sell all the stock. “Let’s say your RSUs are worth $100,000 when they vest. If I gave you $100,000 in cash income instead, would you go out and use that money to buy your company stock? If your answer is no, then that is literally the same, financially, as selling all your RSU shares.”
In her view, “you’re better off selling them all and using the money immediately for some current need (such as a down payment on a house) or other financial opportunity (such as paying off debt), or investing the money in a broadly diversified, low-cost portfolio.”
Chloé Moore has helped many clients strategize for RSU vesting. In one example that she presented during her webinar segment, her approach included:
- Allocated monthly savings, cash bonuses, and sign-on bonus to short-term savings goals.
- Kept 25% of shares that vested after the one-year anniversary (about 30% of the portfolio and a smaller percentage as the portfolio grew).
- Set aside reserves to pay the tax bill (worked with a CPA to estimate each year’s tax liability).
- Sold remaining shares as they vested and split the proceeds between student loans and savings goals, then eventually a diversified taxable account.
Daniel Zajac often suggests that his clients establish a sell schedule. “One strategy that may balance the decision to immediately retain 100% of the shares or sell 100% is to implement a plan that sells a certain number or percentage of shares over a set period. Setting a sell schedule allows you to intentionally reduce your company stock according to a formula. That removes some of the emotional decision-making from the process. You don’t need to guess what the stock price will do next, or decide you will sell when the price reaches X per share, but change your plans once the price does hit that point. You then risk the price going back down before you do sell.”
Mistake No. 5: Getting Bad Advice On Financial And Tax Planning
Stock compensation is a complex employee benefit. “Complex benefits require us to move slowly and think through issues,” says Megan Gorman. She implores employees with equity comp to obtain guidance from a qualified financial advisor and/or tax expert, and to avoid relying on tips from co-workers. Bill Dillhoefer echoed this sentiment, observing that applying advice from “water-cooler” chats with co-workers can lead to mistakes.
Everyone’s individual circumstances differ. Identifying strategies that work for you is yet another good reason to consult a financial planner. “Strategies are incredibly personal,” agrees Megan. “For your own unique situation, you may need to do very different things than your colleagues.”
Further Resources
On myStockOptions.com, the online educational resource with content and tools devoted to all things equity comp, employees and their financial advisors can prepare for stock option exercises and RSU vesting. For more on mistake prevention, see the following articles:
- How To Avoid The Most Common Stock Option Mistakes by wealth advisor Beth Walker
- How To Avoid Mistakes And Create Wealth With Your Stock Options by CFP Paul Palazzo
In addition, all of the financial advisors quoted in this article have discussed planning strategies in detail during webinars that are available on demand at the myStockOptions Webinar Channel.