Employees who receive stock compensation hold partial ownership of their company through these non-cash payouts. While stock options can be a great employee benefit and a good way to build wealth, they also come with complexities and risks that many employers don’t fully explain. Consulting with a CFP® professional can help you make decisions about equity compensation that are appropriate for your overall financial situation.
A stock option is the right to buy equity in the company that employs you at a certain price, with profit potential if the stock value rises and you decide to sell. Stock options are standard in privately held businesses planning an initial public offering (IPO), giving employees an extra incentive to join a company that might not be able to offer the same cash compensation as a more mature organization.
Before exercising stock options, employees must follow a vesting schedule. That means they must work for the company for a specified period to buy these shares.
The three most common types of stock compensation offered by companies to attract and retain employees are as follows:
- Restricted stock units (RSUs)
- Non-qualified stock options (NQSOs)
- Incentive stock options (ISOs) for a new employee
NQSOs add to your annual compensation and increase income taxes, while ISOs don’t boost income but may trigger other taxes.
There are many considerations involved with equity compensation plans, such as investment concentration risk, tax planning and market volatility. Most important is your personal financial situation, which may be different than those of your colleagues.
Here are some strategies to help manage the risks that come with equity compensation:
- Review stock options in the context of your overall investment portfolio.
Do not make decisions in a vacuum. Consider whether to exercise your stock options or when to sell the shares you have obtained. Think about your cash flow needs and how the equity compensation fits into your overall financial picture. Be cautious before adding to your risk exposure and consider how the stock options might affect your ability to achieve your financial goals.
A large part of financial planning is also asking “what if” questions. What if you do not stay at your company long enough for all your RSUs or stock options to vest? What if you hold onto the shares too long and the value plummets? If you consider the potential compensation scenarios, you will be better positioned to make informed decisions. - Ensure that your portfolio remains diversified.
Imagine if you have stock options that make up 40% of your total portfolio. If much of your wealth is concentrated in your company’s stocks shares, your investments may not be adequately diversified to suit your goals and risk tolerance. It’s optimal to avoid too large a concentration of assets in any one company’s stock, particularly your employer.
If too much of your assets and net worth, along with your earning power, is tied to one company, you will have a less diversified portfolio and a greater exposure to risk. - Evaluate the tax implications.
Each type of equity compensation brings its own tax ramifications. For NQSOs, you’ll owe tax upon exercising before you have the liquidity created by selling the stock. Strategizing with a qualified tax preparer and CERTIFIED FINANCIAL PLANNER™ professional can help you take proactive steps to cover your tax liability without having to sell an investment you’d rather preserve.
A CFP® professional can also recommend ways to lower your tax liability, such as holding shares long enough to avoid higher short-term capital gains rates or selling stocks with the highest cost basis first. - Consider how and when you’ll need these funds.
If you have short-term financial goals, such as a plan to purchase a new home in the next few years, keeping too much of your wealth tied up in your company’s stock options may not be appropriate. If you don’t expect to need those funds to meet near-future goals, you’ll have more flexibility in how much stock compensation you keep and for how long.
As soon as you get a compensation package that includes equity compensation, it’s best to talk with a CFP® professional about how it aligns with your life goals and risk tolerance. Find a CERTIFIED FINANCIAL PLANNER™ professional who understands the nuances of equity compensation and can help you make sense of complicated offerings. You can then make informed decisions at every point — from when and how to exercise options to the most tax-advantaged manner to sell accumulated shares.
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