Congratulations, you've just been awarded equity compensation as part of your overall pay, bonus, and employee benefits package. This can be a great opportunity to build potential financial wealth.
But it's not uncommon for employees to be confused by the stock component of their compensation. Some get tripped up, forget critical dates, and haphazardly manage their employee stock awards and option grants. As a result, they may lose out on the many benefits these stock plans can provide.
To help ensure that you maximize your stock benefits, avoid making these 6 common mistakes:
Mistake #1: Failing to consider your equity compensation as part of your overall financial plan
If you are like a lot of people, you may be working with an advisor to create a financial plan that covers a wide variety of investment, personal finance, estate planning, and retirement goals.
If you are an executive, your wealth plan should also include strategies to make the most of executive compensation, ?including Restricted Stock Units (RSUs), Restricted Stock Awards (RSAs), and deferred compensation plans.
Know the difference: Restricted Stock Units and Restricted Stock Awards
RSUs and RSAs can represent a significant part of your total compensation—and should be taken into consideration as you build your overall financial plan.
RSUs give you potential ownership in company stock. However, they have no concrete value until your vesting is complete, and they are assigned a fair market value. Upon vesting, they are considered income, and a portion of the shares is withheld to pay income taxes. You then receive the remaining shares and can sell them at your discretion.
RSAs give you immediate ownership , including voting rights.
A common challenge for many executives is the reporting of RSU cost basis accurately. With RSUs, the part of the tax basis that equals compensation income recognized does not have to be reported on the 1099-B sent to the IRS. Thus, many 1099s report the basis (incorrectly) as $0.
Tip: Make sure to leverage the 1099 supplemental information from your broker. Then, working with your tax advisor, adjust the cost basis on the tax return as necessary. This can help prevent overpaying capital gains taxes by paying tax twice on the compensation listed on your W-2.
Understand the big picture
No matter your level of compensation, it's important to see how all aspects of your financial picture fit together, both short and long term.
For example, the proceeds you generate from selling shares of company stock might be used to maximize contributions to your employer-sponsored retirement plan, pay down debt, make a college tuition payment, or simply diversify your investment holdings.
Taxes can also play a big role in your financial planning. You may wish to consider gifting appreciated shares, or earmarking them for legacy, in order to avoid capital gains tax. If neither is possible, work with your advisor to determine when to sell; this can help to spread out the impact of taxes over time, and that in turn may help keep you out of a higher tax bracket.
Lastly, if you are an executive, you may have access to a deferred compensation program which may allow you to defer a large portion of your compensation and to defer taxes on the money until the deferral is paid. This equity compensation component should also be factored into your diversified investment strategy and overall wealth plan.
Mistake #2: Not knowing the "in the money" factors
A stock option grant provides an opportunity to buy a predetermined number of shares of your employer's company stock at a pre-established price, known as the exercise or strike price. Typically, there is a vesting period ranging from 1 to 4 years, and you may have up to 10 years in which to exercise your options to buy the stock.
A stock option is considered "in the money" when the underlying stock is trading above the original strike price. Say, hypothetically, you have the option to buy 1,000 shares of your employer's stock at $25 a share. If the stock is currently trading at $50 a share, your options would be $25 a share in the money. If you exercised them and immediately sold the shares at $50, you'd enjoy a pretax profit of $25,000.
You may be tempted to delay exercising your stock options as long as possible in the hope that the company's stock price continues to go up. Delaying will allow you to postpone any tax impact of the transaction, and could increase the gains you realize if you exercise and then sell the shares. But stock option grants are a use-it-or-lose it proposition, which means you must exercise your options before the end of the expiration period. If you don't act in time, you forfeit your opportunity to exercise the option and buy the stock at the strike price.
When this happens, you could end up leaving money on the table, with no recourse. In some cases, in-the-money options expire worthless because employees simply forget about the deadline. In other cases, employees may plan to exercise on the last possible day, but may get distracted and therefore fail to take necessary action.
"Ask yourself how much extra value you may get by waiting until the last second to exercise your award, and determine if that's worth the risk of letting the award expire worthless," says Mark Haggerty, head of Fidelity Stock Plan Services.
Consider these factors when choosing the right time to exercise your stock options:
Tip: Monitor your vesting schedule, keep your contact information updated, and respond to any reminders you receive from your employer or stock plan administrator. The key is to have a strategy in place for determining the optimum price and time to exercise options.
Mistake #3: Concentrating too much of your wealth in company stock
Key question: How much of your portfolio are you comfortable having in your company stock?
Earning compensation in the form of company stock or options to buy company stock can be highly lucrative, especially when you work for a company whose stock price has been rising for a long time. At the same time, you should consider whether you have too much of your personal wealth tied to a single stock.
Why? There are 2 main reasons. From an investment perspective, having your investments highly concentrated in a single stock, rather than in a diversified portfolio, exposes you to excess volatility, based on that one company. Moreover, when that company is also your employer, your financial well-being is already highly concentrated in the fortunes of that company in the form of your job, your paycheck, and your benefits, and possibly even your retirement savings.
Second, history is littered with formerly high-flying companies that later became insolvent. When Enron filed for bankruptcy in 1999, more than $1 billion in employee retirement savings evaporated into thin air. Lehman Brothers employees shared a similar fate in 2008 as did Radio Shack workers in 2015. Consider, too, that income from your employer pays your nondiscretionary monthly bills and your health insurance. Should your company's fortunes take a turn for the worse, you could find yourself out of a job, with no health insurance and a depleted nest egg.
"Stock from an equity plan is usually a large component of an executive’s annual compensation, so it's easy for your portfolio to become overly concentrated in your employer's stock," says Haggerty. "But you need to take a step back, consider how these benefits fit into your long-term financial objectives, such as college savings, retirement, or a vacation home, and develop a plan to diversify accordingly."
Tip: Consult with a financial advisor to ensure that your investments are appropriately diversified and read Viewpoints on Fidelity.com: The guide to diversification
Mistake #4: Neglecting the potential impact of taxes on the sale of stock
For many people, especially executives, the ability to fully take advantage of equity compensation benefits is as much a tax decision as it is an investment decision.
In most cases, there will eventually be taxes to pay. But how and when?
There are different tax treatments associated with non-qualified stock options (NSOs) versus incentive stock options (ISOs). Neither one creates a tax event at the time they're granted. But once exercised, they follow 2 different paths.
When the shares acquired via ISO exercise are sold, the entire gain (i.e. the difference between the strike price and the market price you at which you dispose of your stock) may qualify for long-term capital gains rates, but only if the shares are held until the later of:
If the shares are sold on an earlier date than specified above, it’s deemed a disqualifying disposition, and the resulting gain on the sale of stock will be subject to higher tax rates assigned to ordinary income.
So if an executive is unaware of the holding requirements for ISOs, exercises the options and sells too soon, they could forego significant tax savings. On the other hand, bear in mind that once ISOs are exercised, an AMT tax liability may be created immediately, and will not be affected if the price of the stock later declines. In extreme cases, when ISOs are exercised and the stock is held, this can lead to a situation where the recipient is left with a tax liability larger than the residual value of the stock.
The upshot is that while taxes are important, they should not be your sole consideration. You also need to consider the risk that your company's stock price could decline from its current level. "Be aware of your tax situation, but also understand how the company is performing in the marketplace, because there are also risks to continuing to hold the shares," says Haggerty. "Know which shares are qualified for special tax treatment, what the holding periods are, and exercise stock options accordingly."
Tip: Consult with a tax advisor before you exercise options or sell company stock acquired through an equity compensation plan.
Mistake #5: Not knowing the stock plan rules when you leave the company
When you leave your employer, whether it's due to a new job, a layoff, or retirement, it's important not to leave your stock grants behind. Under most companies' stock plan rules, you will have no more than 90 days to exercise any existing vested stock grants. While you may receive a severance package that lasts 6 months or more, do not confuse the terms of that package with the expiration date on your stock grants.
If your company is acquired by a competitor or merges with another company, your vesting could be accelerated. In some cases, you might have the opportunity to immediately exercise your options. However, be sure to check the terms of the merger or acquisition before acting. Find out if the options you own in your current company's stock will be converted to options to acquire shares in the new company.
Tip: Contact HR for details on your stock grants before you leave your employer, or if your company merges with another company.
Mistake #6: Forgetting to update your beneficiary information
As with your 401(k) plan or any IRAs you own, your beneficiary designation form allows you to determine who will receive your assets when you die—outside of your will. If you have made no beneficiary designation, under most plan rules the executor (or administrator) will, in fact, treat equity compensation as an asset of your estate.
Each time you receive an equity award, your employer will ask you to fill out a beneficiary form. Many grants range in life from 3 to 10 years, during which time many factors can change in your life. For example, if you were single when you received a grant, you may have named a sibling or parent as the beneficiary. But 5 years later, you may be married with children, in which case you would likely want to change your beneficiaries to your spouse and/or children. The same holds true if you were married and got divorced, or divorced and remarried. It's important to always update your beneficiaries.
Tip: Review your beneficiaries for your equity awards—as well as your retirement accounts—on an annual basis.
Next steps to consider
Call or visit to set up an appointment.
Create your plan for retirement income.
See articles on estate planning, managing wealth, and family legacy plans.