Many of us have heard the stories about “Walmart millionaires”: people who went to work for the retail giant in its early days and began accumulating company stock with payroll deduction. For some of these folks, what began as a hundred or so shares worth $16.50 each in the 1970 initial public offering was transformed over the years into holdings worth many hundreds of percentage points and many hundreds of thousands (or millions) of dollars more.
Though perhaps less dramatic, a similar situation can occur for successful executives and CEOs. By accumulating various forms of executive compensation such as restricted stock units (RSUs), incentive stock options, bonuses, and others, they may build significant wealth over the course of a career.
But especially when it comes time to plan for retirement, these important wealth-building assets require some careful planning and timing in order to allow the executive to build a more diversified, tax-efficient source of retirement income. Understanding restricted stock units, options, and stock grants, as well as how each of these forms of compensation works and their implications for tax planning and liquidity needs, involves the formation of a well considered strategy and plenty of time to implement it.
What are RSUs, and how do they affect tax brackets?
Restricted stock units are basically bonuses paid in company stock instead of cash. Typically issued according to a vesting schedule that may involve length of service, achievement of certain corporate goals, reaching certain benchmarks, or some combination, RSUs belong to the recipient upon vesting. At that time, they are also recognized as taxable income, according to the value of the stock at the time of vesting. So, in any year when an executive receives vested RSUs, the value of the units is added to any other compensation paid to the executive during the year to determine taxable income and the marginal bracket for that year.
What about stock options and company stock?
Stock options are a little different. Instead of representing actual shares of stock, they signify the recipient’s ability to purchase a stated number of shares at the option price (sometimes called the “strike price”). Though there are slight differences among option types, they generally become taxable when the option is exercised and actual shares are purchased. The amount that is taxed usually depends on the “spread”: the difference between the purchase price guaranteed by the option and the stock’s current market value. For example, if an executive holds options that allow the purchase of stock at $50 per share, and if, upon exercise, the market value of the stock is $100 per share, the spread would be $50. Incentive stock options (ISOs) don’t typically generate ordinary income at the time of exercise, though for some high earners, they may trigger alternative minimum tax. Non-qualified stock options (NSOs) generate ordinary income based on the spread at the time the options are exercised. Later, if the stock (either from ISOs or NSOs) is sold at a higher price than its market value when purchased, that gain would be taxable at the rate for capital gains (typically lower than the rate for ordinary income when held greater than one year).
Equity Compensation, Taxation, and Liquidity Needs
Because extra taxable income (and additional tax liability) is generated in years when equity compensation is received (or stock options are exercised), it is wise for recipients to plan ahead for the extra liquidity needed to cover both the exercise of options and the taxes due on the resulting income. For publicly traded companies, this may be as simple as selling a portion of the shares received to generate sufficient funds. For privately held companies, it can be a little more complicated; depending on the specifics of the plan, recipients may have to wait for a “liquidity event”: an IPO, merger, acquisition, or something similar. In some cases, it may be possible to borrow against the value of privately held shares, but this depends on what the plan allows.
For those using the value of equity compensation to fund retirement, liquidity planning typically involves a plan spanning several years prior to the desired retirement date. This can allow the retiring executive to make orderly disposition of the stock while spreading any capital gains tax burden out over a longer period of time. Some retiring executives may even plan to gift appreciated stock to a family member as part of estate planning or to charity as part of a philanthropic effort.
Should you diversify a concentrated position?
Another aspect of equity compensation that deserves discussion is the issue of a concentrated position, or concentration risk. Sometimes, executives will accumulate a large position in company stock, to the point that a significant percentage of their net worth is represented by a single asset. This results in a concentrated position: the owner’s financial position is vulnerable to financial, competitive, or economic developments that would negatively affect the company and the value of its stock.
Especially for those who will depend on the value of their holdings to fund a secure retirement, it is usually best to avoid accumulating a concentrated position as the result of executive compensation. Instead, it may be advisable to “unwind” the position over a period of time to permit diversifying the portfolio away from over-reliance on the value of company stock. This process typically requires careful coordination between the financial advisor and the tax expert; by calibrating the amount of shares to be sold in a given year and also by taking advantage of tax-loss harvesting and other tools, the concentrated position may be reduced with greater tax efficiency. And this can often take careful coordination with insider information protocols that many positions can have access to sensitive information and needs to get approval from compliance or be in an open window to be able to sell the stock position.
Your advisor at The Planning Center can provide individualized guidance on managing your executive compensation package in the way that is most beneficial for your retirement planning and other important financial considerations.
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