Planning for Early Retirement When You Have Equity Compensation
Employee stock benefits come with some risks and strings attached, as well as the potentially rich possibilities they afford. So know what you’ve got and how to use it.
No matter where you are at in your career, thinking and planning for retirement should be top-of-mind. For employees with equity compensation packages, you may have already reached your retirement goals if you include the value of your package. On the other hand, you may need to take a deeper look into your finances before you make the jump into retirement.
Equity Compensation Explained
Equity compensation is any compensation that is based on the value of specified stock (generally, the stock of the employer). It usually imposes a vesting period, which encourages you to remain with the company for a certain time to receive the benefit. This is particularly true as equity compensation might be accompanied by a below-market salary.
However, equity compensation is not just of value to the employer wishing to retain outstanding talent. It can also be central to the retirement plan of those same employees. If you picked the right company — one whose stock price grows substantially during your tenure there — the value can be a critical component of your retirement plan.
Using Equity Compensation for Retirement Planning
More than half of employees receiving equity compensation expect to use it as part of their retirement. According to Plan Adviser, the average vested balance is over $97,000 and the average total value for a worker’s equity compensation is almost $150,000. However, to use the shares for early retirement, you need to be sure that you have met all of the requirements for vesting these shares.
Current evidence indicates that fewer than one-fourth of employees have ever exercised their stock options, according to CNBC. If you do plan to exercise your options and use your equity compensation in retirement, you might have to satisfy certain conditions, including an age-at-retirement requirement and a length-of-service requirement. However, it is important to note that, even if you meet these requirements at the time you decide to retire, it is possible that under a company plan you still may not be entitled to receive any of your unvested shares.
Instead, such shares could be forfeited, continue vesting on the original schedule, or, in some cases, may vest immediately. Be sure you understand exactly how your plan works. A financial professional can give you useful guidance here as well.
Holding on to the Shares – or Not
One of the most basic rules of an investment portfolio is that diversification is perhaps the primary risk control. A diversified portfolio may protect those who do not spend their full time watching their stocks; as Warren Buffett said, "Diversification is protection against ignorance" for the non-professional investor.
A danger that using equity compensation presents in retirement is that, by its very nature, it is not diversified. In other words, as you get older, by relying on your equity compensation portfolio and company stock, you could be overexposed to risk in the stock of one individual company — your employer — in a manner that no longer fits your investment profile.
Even when you recognize this risk, managing it can be difficult. There are several ways to approach this problem. If you have received more than one type of equity compensation, you may be able to use them strategically to assist in diversifying your risk. On the other hand, if you have a financial or emotional reason to continue to hold the concentrated position, you may want to be aware of what this will mean for your retirement fund. You should determine if you are dependent on this money or if it is extra.
Similarly, it is also possible to hold the concentrated position or sell it into the market. In any case, you should realize that a concentrated portfolio may be more volatile than a diversified one, which may present more risk than the soon-to-be-retired you wishes to carry.
Once you decide how much of the equity compensation you want to continue to hold, an investment professional can guide you toward a variety of investment strategies. One example may allow diversified assets to produce income to cover your “early” retirement years without touching tax-qualified assets that might incur penalties or taxes. You should also consider your continuing involvement with your company, which will affect how quickly and how much you wish to sell.
Planning for Taxes
If you decide to reduce or liquidate the equity compensation position, it is also important to remember that liquidating those shares may very likely create tax consequences for you. There can be both ordinary income and capital gains taxes on the shares, and the timing and payment of these taxes need to be planned for as well. Failure to do so can have a significant adverse effect upon your retirement assets. Retirement income is taxed in several different ways, and planning for that is essential.
You will need to plan the timing of your liquidations to spread out the tax consequences, as well as your retirement cash flow. You should work with your financial professional to explore ways to generate income from the shares you continue to hold. They can also help you with planning to cover taxes that will arise from investment income, sales of shares and, eventually, from withdrawals from your retirement accounts.
Equity compensation can give you an important bridge from early retirement to the age when your other retirement assets become available. Using those shares to produce income over the years of early retirement will make possible the later, penalty-free use of traditional retirement assets.
Advisory services offered through Capital Analysts or Lincoln Investment, Registered Investments Advisers, Securities offered through Lincoln Investment, Broker/Dealer, Member FINRA/SIPC. www.lincolninvestment.com. SimoneZajac Wealth Management Group, LLC and the above firms are independent and non-affiliated.
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About the Author
Partner, SimoneZajac Wealth Management
Daniel Zajac is a CFP® and partner with SimoneZajac Wealth Management, located just west of Philadelphia in Exton, PA. Zajac is involved in new business development, serves as a lead adviser with existing clients and is charged with leading negotiations on strategic business acquisitions. His blog was named one of the top 50 Financial Advisor Blogs and Bloggers by kitces.com in February 2016.