personal finance

4 Potential Problems with Equity Compensation, and How to Solve Them

Anyone who receives stock options, restricted stock units or other forms of equity compensation needs to understand how they work and how they are taxed. Otherwise, you could miss out on a great opportunity, or get hit with a surprise bill.

Non-cash compensation might not sound like a very good deal for you as an employee — but depending on the type, it can actually provide quite a boost to your net worth over time. Equity compensation is a type of “non-cash” comp that your company may provide, but that doesn’t mean it doesn’t have value.

Equity compensation provides you with shares of equity in your company, allowing you to take advantage of potential upside growth. If the company as a whole does well, then you, as an owner of some of the equity in the business, do too through a rising stock price that can help lift the value of your investment portfolio and provide a profit if sold.

Common forms of equity provided to employees in compensation packages include:

  • Incentive stock options (ISOs)
  • Restricted stock or restricted stock units (RSUs)
  • Non-qualified stock options (NQSOs)
  • Ability to participate in employee stock purchase plans (ESPPs)

You may also see equity like phantom shares or performance units. Every company is different, so it’s important to understand what type of equity compensation you have if it’s offered to you.

Equity compensation can drive the overall value of your earnings and investments up — but that doesn’t mean it’s all benefits and no risks. There are serious problems that can crop up if you don’t manage this portion of your compensation well.

Here are four potential trouble areas to watch out for, and what to do about them:

1. Equity Compensation Introduces a Lot of Complexity into Your Financial Plan

While RSUs and ISOs may both be types of equity compensation, they are each very different. Even ISOs and NQSOs, while they sound similar, behave differently — especially when it comes to the tax implications of receiving, exercising and holding shares.

Every type of equity comp carries its own parameters and nomenclature that you must know. Failure to fully understand the nuances of the specific kind of equity you might have access to can cause serious issues down the road, including massive bills come tax time or missed opportunities if expiration dates come and go.

You should refer to your plan document to understand exactly what kind of equity compensation you have and all the rules around managing it. Some important terms and conditions to look out for may include:

  • Grant and vest dates
  • Strike price
  • Exercise date
  • Trading windows
  • Blackout periods
  • Lookback provisions and discounts (for ESPPs)

You might also want to discuss tax planning considerations with a financial adviser and a CPA. Not all equity compensation is taxed the same way, or even at the same time. ISOs, for example, may not be taxed when your options are granted to you … but RSUs are taxable the moment they vest and become yours.

2. Equity Compensation Isn’t Always Readily Accessible

Almost all types of compensation awards come subject to a vesting period. That means that equity compensation might be part of your compensation package from Day One … but until that equity actually vests, it’s merely a promise your company makes to uphold at a future date.

Vesting periods are often one to two years. During this time, things like stock options or RSUs are not technically yours, and you cannot sell them or rely on a particular value because the share price may change drastically during the period.

Even when your stock or options do eventually vest, your ability to act on them can be limited. Many come with stipulations around trading windows, which provide a limited amount of time in which you can buy or sell shares once you own them.

Vesting schedules or holding periods are not inherently bad things. They just need to be accounted for in your planning process. 

3. Have Equity, Will Pay Tax

There’s no such thing as a free lunch, especially on something that holds considerable value. The IRS will certainly want a piece of any appreciation or profits that come from your equity compensation, and you need to be aware of exactly how your specific type of shares will be taxed — and when.

Speaking with a tax adviser about your equity compensation can help you plan appropriately so that you are not taken by surprise when you file your taxes and realize you should have set aside more to cover the obligation created by a sale of equity.

Here are some things you may want to consider:

  • What counts as a taxable event, based on the equity compensation I have?
  • Are my taxes going to be significant enough to drive the decisions I make around equity compensation, or are other priorities more important?
  • Will I do a qualifying or disqualifying disposition for options that I exercise? What is the best course of action in the context of my whole financial plan?
  • When will I be subject to the alternative minimum tax, and how can I plan appropriately for that?

Finally, you may think you’re covered from a tax standpoint if taxes are automatically withheld before shares are granted to you. This can happen with vesting RSUs, for example. Your company may withhold up to 22% of the value of the shares to pay taxes, which might be sufficient … or it could be far short of what you actually need to pay.

Your actual tax rate could be above 30% because RSUs are taxed as ordinary income. If you’re already well-paid through your normal W-2 salary, the value of vested RSUs may push you into higher tax brackets, which will increase how much you owe.

4. Equity Compensation Can Create Concentration in Your Investment Portfolio

It’s very easy to amass a concentrated position in your company’s stock if you automatically have equity compensation coming to you through options, RSUs or shares purchased through an ESPP. Unless you actively manage this, you may end up overexposed to your company and with a far riskier portfolio than is appropriate.

We generally don’t like our clients having more than 10% of their net worth tied up in any one stock. Having this kind of concentration puts a lot of volatility into your investments, and ties your financial success to the well-being of a single asset or business.

If that business also signs your paychecks, that introduces yet another level of risk that your financial plan may not actually be able to handle.

It’s a tricky balance to strike, especially in some industries — such as tech — where paying employees in equity that tends to spike in value is the norm.

So, what should you do if you find yourself in this position? This is where a comprehensive financial plan can come into play. It provides you with an outline of actions to take based on everything else in your financial life, from your other assets and overall balance sheet to the goals you want to accomplish and what it will take to achieve them.

There’s no blanket piece of advice that works for everyone with equity compensation; you must consider all of these factors when figuring out to sell or hold your company equity as well as the right moves to make to manage it well over time.

Think about your goals and consider consulting both planning and tax professionals. Don’t take this decision lightly, because you have a serious tool at your disposal. Equity compensation can help significantly grow your wealth over time — but only if you properly manage the risks that it comes with on your way to enjoying the rewards.

About the Author

Paul V. Sydlansky, CFP

Founder, Lake Road Advisors, LLC

Paul Sydlansky, founder of Lake Road Advisors LLC, has worked in the financial services industry for over 20 years. Prior to founding Lake Road Advisors, Paul worked as relationship manager for a Registered Investment Adviser. Previously, Paul worked at Morgan Stanley in New York City for 13 years. Paul is a CERTIFIED FINANCIAL PLANNER™ and a member of the National Association of Personal Financial Advisors (NAPFA) and the XY Planning Network (XYPN). In 2018 he was named to Investopedia's Top 100 Financial Advisors list.

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