Paying employees with equity compensation is far from a new practice. Companies have been offering stock-based compensation for years to maintain cash reserves, attract and retain talent, and align employees’ and organizations’ self-interests.
Equity compensation can vary drastically across plans. Even the same type of plan can look different from one company to the next, which is why it’s crucial to understand what you have, how your plan works, what decisions need to be made, and when.
Here is a quick rundown of the most common types of equity compensation:
- Restricted Stock Units (or RSUs): Instead of receiving a cash bonus, employees compensated with restricted stock units receive unvested shares of company stock that they take possession of in the future, assuming they are still employed with the company at that time. It is most common for RSU grants to vest gradually (i.e., graded vesting) or all at once (i.e., cliff vesting) over three to five years. The value of these shares could be worth substantially more or less than they were on the grant date by the time they vest.
- Stock Options: Incentive stock options (or ISOs) and nonqualified stock options (or NSOs) are less common and far more complex than RSUs. Instead of receiving unvested shares of company stock, employees receive the right to purchase company stock at a specific price (i.e., strike price), usually equal to the price of company stock on the grant date. Stock options are subject to vesting schedules, too, and the right to purchase stock eventually expires, usually five to 10 years after the grant date, potentially sooner in some circumstances. Employees with unexercised stock options can participate in the potential future upside of company stock without putting any of their money at risk until exercise, offering the significant advantages of positive leverage, tax-deferred growth potential, and downside protection.
- Employee Stock Purchase Plans (or ESPPs): These plans aren’t directly tied to compensation, but instead let employees purchase company stock at a discount to fair market value.
Common Mistakes With Equity Compensation Plans
Given the head-spinning complexity and high-stakes implications of equity compensation, employees can often be overwhelmed by the decisions that must be made with these plans, resulting in action (or inaction) with adverse and unintended outcomes.
Here are 10 common mistakes employees make when working with equity compensation and how you can avoid them:
1. Not understanding your equity compensation plan.
Be sure to review the key features of your stock plan, including vesting schedules, expiration dates, purchase periods, trading windows, holding requirements, tax treatment, etc. Carefully read through your plan document and grant agreements if you haven’t already.
2. Not managing your equity compensation as part of a comprehensive financial plan.
It’s impossible to get the most out of a stock plan (or any investment strategy) without knowing what the money is being used for. Set a goal and leverage your equity compensation as part of a larger plan to achieve it.
3. Failing to withhold enough for income taxes.
Your employer’s default is likely to withhold 22% for federal taxes for newly vested restricted stock and exercised NSOs. If your marginal tax bracket is greater than 22%, this might not be enough to cover your tax bill and avoid underpayment penalties.
Taxes are never withheld from ESPPs, making them common culprits of surprise tax bills when company stock is sold. There is also no tax withholding on the exercise of ISOs, which could get you into hot water if you are subject to the alternative minimum tax (or AMT) or regular income tax (if you sell stock in the same calendar year the ISOs were exercised).
4. Letting the ‘tax tail wag the dog.’
Though taxes matter, they shouldn’t be the only factor you consider when making compensation decisions. When deciding to hold or sell company stock awarded through an equity compensation plan, prioritize what makes the most sense for the specific goal you are funding and your overall exposure to company stock in the rest of your portfolio.
5. Using company stock to fund short-term goals.
Company stock never makes for an ideal emergency fund — nor is it a good source for funding short-term goals. Instead, all known expenses in the next one to three years should be held in cash, unless you know you’ll have the cash flow available to cover them.
This doesn’t mean you can’t ever use equity compensation to fund short-term goals. Maxing out ESPP contributions can be a great way to pay for your child’s college tuition next year, assuming the newly acquired stock position is sold immediately after purchase. In doing so, you lock in the gain received from the ESPP discount and have more money to cover the expense than you’d have by simply saving in cash.
6. Investing too heavily in company stock.
Holding stock in your company means your investments and income are both on the line with your employer. If you get laid off, the company stock position in your portfolio probably wouldn’t be doing well either. Even if you don’t get laid off, you might not always get the raises or bonuses you expect; and if you’re holding too much company stock, your portfolio might not be in a favorable position to cover the difference.
A good starting point is to keep your exposure to company stock at less than 5% of your portfolio. In some circumstances, it might make sense to hold substantially greater than that amount. It could also be advisable to hold none at all. The right answer depends on your appetite for risk and the strength of your overall financial plan.
7. Stopping ESPP contributions due to poor performance.
When the value of your company stock falls drastically over six to 12 months, it can be tempting to stop contributing to your ESPP. However, remember that participation in an ESPP doesn’t mean you must hold company stock after purchase. In fact, if your ESPP has a lookback provision, contributing to your plan after a substantial decline might be more favorable than before, especially if the stock rebounds in the months ahead.
8. Asking colleagues for tips and suggestions.
Even if your colleagues have a better grasp on the equity compensation plan than you do, they’re still missing a deep understanding of your financial situation. What makes sense for one person might be potentially catastrophic for another. If you’re unsure of the best way to manage your equity compensation, partner with a professional wealth manager with extensive equity compensation planning experience.
9. Losing stock-based compensation through job termination.
Should you choose to leave your job, it’s important to time it right or risk losing the total value of your stock-based compensation. For instance, don’t leave days before your next round of RSUs or stock options vest. Also, it is important to note that unexercised stock options often have accelerated expiration dates after separation from service, usually three to six months after you leave the company.
If you’re looking to make a job change, check the vesting dates of any unvested equity compensation before taking the leap. Also, take note that unexercised stock options are typically subject to an accelerated expiration date after separation from service, usually one to six months after leaving.
10. Defaulting to ‘FIFO’ tax lots when selling stock.
The company stock you’ve held the longest will likely have the highest unrealized gains. So, you likely won’t want to opt for the “first in, first out” approach. Instead, be strategic about selecting specific lots that allow you to sell company stock in the most tax-efficient way possible.
Equity compensation can be a powerful tool to help you build and maintain long-term wealth. Given its complexity and potentially high-stakes nature, it’s not a good idea to just “wing it” with equity compensation and hope for the best. It takes thoughtful, proactive planning and intentional action to make the most of stock-based compensation and circumvent the most common costly mistakes.
Derek Jess is a Senior Wealth Manager and shareholder at Plancorp (https://www.plancorp.com/), a full-service wealth management company serving families in 44 states. With specializations in financial planning for employees with equity-based and deferred compensation plans, he helps high-income clients with complex needs navigate through all stages of life.