Money Matters

How to Avoid Equity Compensation Tax Mistakes in Your Retirement Planning

More employers, such as start-ups and tech companies in San Diego, are offering equity options within their compensation plans to align employee and employer interests, provide long-term incentives, and attract and retain talent. As employees continue to play an integral role in the company’s success, equity compensation is a powerful tool for rewarding high performers, reinforcing their commitment to the company’s long-term growth, and providing an opportunity for financial gain.

As you approach retirement, you’ll face intricate financial decisions, especially if you hold company stock or equity options. With tax complexities and the allure of future gains, it’s common to feel overwhelmed working equity compensation into your comprehensive retirement plan. Common questions may arise, such as:

  • Should I hold my company stock until retirement, or sell it?
  • How can I minimize my tax liability when selling my equity compensation in retirement?
  • Are there exercising restrictions as I approach or am in retirement?

From planning your retirement income to managing your tax liability and overall investment risk, it’s crucial to understand how these options work to make the most of your shares, particularly if you plan to retire soon. We’ll explain six common mistakes to avoid before retirement if you own company stock, restricted stock units (RSUs), or stock options. But first, let’s explain equity compensation and its role in retirement planning.

What is Equity Compensation?

Stock options are forms of equity compensation companies offer their employees as ownership or shares in the company. It is a way for employers to give employees a stake in the company’s success and align their interests with those of the company, its culture, and its shareholders. For example, if the stock increases, employees can purchase shares at a discount and profit once they meet certain conditions. Other benefits include these three:

  • An alignment of interests can yield significant benefits over time, as employees who consistently perform well, advance in their roles, and contribute to the company’s growth often receive additional compensation through equity grants.
  • Subject to vesting periods, equity compensation encourages employees to stay with a company longer. As employees’ equity awards vest over time, they become eligible to exercise their options, reinforcing a sense of  loyalty.
  • Certain types of equity compensation may offer tax advantages that can potentially reduce an employee’s overall tax burden.

What Are the Different Types of Equity Compensation?

Each type of equity compensation has its unique features, benefits, and tax implications. It’s crucial for employees to understand the specifics of the equity grants offered by their company and consider their financial goals, risk tolerance, and overall retirement planning when deciding how to manage their equity compensation. Common types of equity compensation include:

  • Stock Options: Stock options give employees the right to purchase a specific number of shares of the company’s stock at a predetermined price within a particular time frame. The hope is that the company’s stock price will rise above this price, allowing the employees to buy the stock at a discount and realize a profit when they sell it.
  • Restricted Stock Units (RSUs): RSUs are actual shares of company stock that are granted to employees but subject to a vesting schedule. This means employees receive the shares outright only after satisfying certain conditions, such as remaining with the company for a specified period. Once vested, the employees can sell the shares or hold on to them as regular shareholders.
  • Employee Stock Purchase Plans (ESPPs): ESPPs allow employees to purchase discounted company stock through payroll deductions. These plans often have specific offering periods and purchase dates.

What Are the Benefits of Equity Compensation for Retirement Planning?

Incorporating equity options like stock options and RSUs into an overall retirement plan can be a valuable strategy to build wealth and enhance financial security during retirement. Employees can work equity options into their retirement planning in various ways, such as:

  • Building long-term wealth if the stock performs well over time
  • Passing options down to heirs in an estate
  • Using them as another source of retirement income before other benefits become available if the employee sells vested shares strategically

Now, let’s discuss six common mistakes you should consider to maximize the benefits of your equity options, especially in your overall retirement income planning and tax strategy.

#1 Not Knowing How High Stock Concentration Affects Your Retirement Plan

Concentration in a stock is the proportion of an individual’s investment portfolio that is invested in a particular stock or a small group of stocks. It indicates how heavily an investor is reliant on the performance of a specific company or companies for their overall investment returns.

When an investor has a large portion of their portfolio invested in a single stock or a few stocks, they are said to have a high level of concentration risk, which is a common challenge for employees receiving company stock as compensation. While an investor can experience significant gains if the stock performs well, the same is true inversely if the stock performs poorly due to market conditions, industry-related issues, or a leadership change. 

Holding too much company stock or not moving away from a concentrated position can be risky due to market unpredictability and volatility, as your retirement nest egg could be tied to one company’s performance, thus all your eggs are in one basket. You can avoid this by diversifying your portfolio and hedging your exposure. For example, consider selling some of your company stock and investing in other asset classes expected to perform differently than the company stock. Diversification should serve you well in your retirement years when you’ll likely want less volatility in your portfolio and a more predictable source of income.

#2 Selling Too Much, Too Soon Before Retirement

If your company stock has appreciated significantly or you have other financial needs, it may be tempting to sell as soon as you retire without considering the long-term implications. However, this can be a mistake if the stock is still expected to grow over time or pays dividends. You could be missing out on substantial gains later or an opportunity for additional retirement income. Giving into emotional decision-making and impulsive reactions to market fluctuations rather than following a sound financial plan can lead to substandard results. On the other hand, an emotional attachment to a company and its stock can similarly affect objective decision-making.

Instead, you may want to consider selling gradually and holding on to some of your stock so you can continue to participate in the company’s possible future growth. One strategy we’ve shared with clients is to sell a piece of the shares upon retirement, sell another portion later, and keep the remainder for the long term, provided it is less than 10–15% of your overall portfolio.

#3 Not Considering the Tax and Retirement Consequences of Selling

Equity compensation can have complex taxation. Unexpected tax consequences of selling equity shares can have significant financial implications and may affect your ability to achieve your retirement goals.

The sale of shares, particularly those acquired through stock options or RSUs, can trigger capital gains taxes. Certain options have distinct tax treatments, so understanding their complexities and nuances is essential to optimize your approach. Consider the tax implications of selling your shares to try to offset capital gains and minimize your tax bill. Work with a financial advisor or tax professional to use tax-loss harvesting or sell stocks in a tax-advantaged retirement account, such as an IRA or 401(k). Additionally, if you don’t hold or sell from these types of accounts, you could be missing tax-deferred growth, further affecting your retirement income.

You may plan to sell some of your stock to diversify or handle spending needs. Consider if you can delay some or all of the sales until the years after you retire, when your taxable income may be lower because you’re no longer working. The taxable gain from the sale will be added to a lower income amount, so you might be able to reduce the overall tax cost of the transactions. If you have extremely low basis shares through your company stock grants and are charitably inclined, you can also consider gifting appreciated options to help defer some of the capital gains and support causes you care about.

#4 Not Exercising or Vesting Company Stock Options

The option term or expiration date within an equity compensation agreement is when employees can exercise their stock options. It also represents the period when options are valid, and an employee can purchase stock at the fixed “strike” or exercise price, which is set when options are granted. The strike price doesn’t change despite market price changes. If you have stock option grants that are either unvested or unexercised by their expiration date, you will likely lose those shares upon retirement. Failing to leverage the overall benefits of your options could result in lost compensation or missing out on future growth that could affect the total value of your retirement savings. 

To make timely decisions and manage your shares, ensure you understand the terms and conditions of each grant, including vesting schedules and strike or exercise price, to leverage and potentially maximize your shares before you officially retire. For example, you may consider exercising your options and selling the stock immediately before or after retiring.

The financial health and performance of your employer company can also influence your decisions regarding equity compensation. Understanding the company’s current and projected outlook can be essential for making informed choices.

#5 Not Evaluating Net Unrealized Appreciation (NUA) for Retirement Tax Planning

NUA is a tax strategy for company stock in an employer retirement plan, such as a 401(k), that allows employees to receive a tax advantage when they retire and begin taking distributions from their plan. NUA is the difference between the cost basis (the price you paid for the stock) and the stock’s market value at the time of distribution from the 401(k) plan. In other words, NUA is the appreciation of the stock that has yet to be taxed. 

When the 401(k) distributes the stock, the cost basis is taxed at ordinary income tax rates, which could result in a larger tax burden, while the NUA is taxed at the long-term capital gains tax rate, which is usually lower. This benefit is why NUA is worth considering for retirees with a large amount of company stock in their 401(k) plan who expect significant appreciation in the future. NUA is also a good strategy for retirees in a high tax bracket while working who anticipate being in a lower tax bracket in retirement. 

NUA can be complex, and the tax implications can vary depending on individual circumstances. It’s crucial to consult with a financial advisor or tax professional who can provide personalized guidance based on your specific situation and retirement goals. Read more about the benefits of NUA.

#6 Not Considering Your Overall Financial Picture

Comprehensive retirement planning is not just about your company stock—at least it shouldn’t be. Overlooking your total financial picture when considering equity compensation can be a mistake that can significantly affect retirement planning and goals. While a valuable part of your overall compensation package, viewing it within the context of your entire financial situation is essential.

Think about other areas of your finances, including any pensions, Social Security, other assets, and your tax situation when deciding what to do with your company stock. A holistic financial planning approach should align with your retirement timeline, diversify, and consider other retirement-savings strategies such as maximizing contributions to an IRA or 401(k). If you already have a diversified portfolio with multiple sources of income, perhaps you can hold on to your stock. Alternatively, consider the guidance and strategies in this post if you only have company stock.

How to Maximize Equity Compensation in Retirement Planning

Working with a financial advisor can be a game-changer if you hold company stock and are approaching retirement. At CCMI, we can help you maximize the features of your equity compensation and put you on a path to reaching your retirement goals using strategies such as:

  • Comprehensive Financial Planning: Our team can help you develop a holistic and customized plan that considers your equity compensation, other investments, retirement goals, risk tolerance, and total financial and tax situation. A bird’s eye approach to your finances can help you integrate other financial aspects you may have yet to consider, such as your estate plan, risk management, and other factors such as retiring in San Diego.
  • Diversification: An advisor can help you implement diversification and reinvestment strategies to reduce your concentration risk, spread your investments across different asset classes, and balance your portfolio.
  • Tax-Effective Planning: A financial professional can help you navigate the complex rules and implications of your equity options to develop strategies for exercising, selling, or transferring stock while managing your tax liability at different income levels.
  • Retirement Income Planning: Financial advisors can evaluate your various assets and benefits to provide retirement income planning advice to help you time your withdrawals, manage your cash flow, generate sustainable retirement income streams, and maintain your desired lifestyle.
  • Regular Monitoring: When you partner with us, we will regularly plan for concentration risks, help you rebalance your portfolio, and reallocate your assets based on your targets. Additionally, we’ll assess the status of your vested stock options, exercise decisions, and ensure they align with your retirement and financial goals.

Remember, these are general guidelines; you should always consult a financial advisor or tax professional for personalized advice based on your financial situation. Working with a financial advisor can provide valuable guidance, reduce mistakes, and help you navigate the complexities of equity compensation and retirement planning. Additionally, there are several more characteristics of equity compensation and strategies to evaluate, such as if you should make an 83(b) election within your RSUs, what to do if you decide to leave your company, and what to know if your company is privately held. 

At CCMI, we can help you make informed decisions, optimize the benefits of your equity grants, and develop a well-rounded financial plan that addresses your retirement goals while managing potential risks effectively. Contact our team, as we’re happy to have a conversation with you about your company stock as you approach retirement. 

PLEASE SEE IMPORTANT DISCLOSURE INFORMATION at https://myccmi.com/important-disclosures/

CCMI provides personalized fee-only financial planning and investment management services to business owners, professionals, individuals and families in San Diego and throughout the country. CCMI has a team of CERTIFIED FINANCIAL PLANNERTM professionals who act as fiduciaries, which means our clients’ interests always come first.
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Matt Showley is a CERTIFIED FINANCIAL PLANNER™ professional and Accredited Estate Planner®️ who advises individuals, families, and business owners on portfolio management, financial planning, tax and estate planning, real estate, cash-flow modeling, and education planning. In addition to his role as principal and owner, Matt continues to oversee the firm’s operations and work with new and existing clients. Matt joined CCMI in 2006 and has contributed significantly to the firm’s wealth management and financial planning processes and client relationships.

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