Many companies now award their workers with stock in the form of Restricted Stock Units (RSUs). This helps retain talent and it gives employees a vested interest in the success of the business. However, large equity awards can create unique challenges for recipients – how much to sell, when to sell, how to consider tax implications, and where to invest the proceeds. If left unmanaged, these awards can grow to represent a large portion of a client’s portfolio and pose outsized risks to performance and the ability to safely meet one’s financial objectives.
To make the most of employer stock compensation, ask yourself the following question… If you received an annual bonus from your employer for $50,000, how likely would you be to immediately invest it all in the stock of your company?
Of course, most people do not immediately buy their company stock with a holiday bonus. However, investors show a strong bias toward holding their vested RSUs – one of the more commonly awarded equity ownership for our clients. Why does this occur? The answer may have nothing to do with taxes or the value of the shares.
RSU shares, unlike stock options, are taxed as income when they vest – just like a bonus payment from one’s employer. The resulting stock carries a cost basis of the price on the day of vesting –as if that cash bonus was used to buy company stock.
For these reasons, RSUs are essentially a bonus which is paid in the stock of one’s employer.
Many times, the decision to hold sell shares seems to be the result of the way in which they are awarded. The field of Behavioral Finance has shown that most people are not perfectly rational and show a strong bias toward the status quo. Employees are simply much more likely to keep the compensation they are awarded – be it stock or cash.
Large stock awards can add up over time, if not diversified, to create concentrated holdings in one company. This behavior can be risky and difficult to remedy for several reasons:
- The risk of a large allocation to one stock is magnified, when that company is also your employer. One company is responsible for driving portfolio growth and providing your paycheck. If things go wrong, one’s income and nest egg can suffer greatly.
- It can be especially difficult to diversify concentrated stock holdings as time goes on. Larger allocations are typically the result of stellar stock performance. Investors often have difficulty selling and diversifying the proceeds from their most successful investments – “Why would I sell my best performing investment?” If/when concentrated stock positions fail to perform, they may also be difficult to sell and diversify, as investors look back on past performance and may want to wait for a past high price to return. This may never happen. If it does, one may be optimistic again and delay sales further. This behavioral cycle can be difficult to break.
- While RSUs are taxed as income when they vest, shares which have been held for many years may carry unrealized capital gains. Many investors use avoidance of capital gains taxes as a reason to keep a large portion of their portfolio in their company stock. This justification can do a disservice to investors. Individual equities tend to be much more volatile than clients’ diversified portfolios. Share prices may move suddenly. Take, for example, an investor holding on to low basis employer stock in order to avoid 15% Federal long-term capital gains taxes. The stock is trading at $100 per share, but drops quickly to $85. Taxes are deferred but the stock is worth 15% less. Tax implications are important to consider and one should always consult a qualified tax advisor. However, capital gains deferral should not be the only reason to hold a stock!
After an eight-year bull market in equities, we believe that now is the time for investors to pay special attention to their employer stock and options. A systematic strategy to sell and diversify may be appropriate to reduce portfolio risk and better pursue one’s financial plans.
In our experience, the most successful diversification plans remove emotion from the sales. A schedule is prepared, agreed upon, and then executed. Ideally this is done with limit orders or a fixed number of shares to sell each month. Highest basis shares are sold first to minimize gains on sales. However, taxes are not the key driver of the investment decisions.
Clients may want to hold onto some employer stock so they may participate in potential future growth of the company. However, ideally that allocation could drop in value to $0 and not jeopardize their financial plans. This is something which we can test using our EMX financial planning software, on a case-by-case basis.
The right sales schedule and resulting allocation to one’s employer stock is different for each person. Sales plans should be tailored to one’s objectives, time horizon, and percentage of portfolio invested in employer stock, among other considerations.
If you’d like to speak with us regarding a more concrete plan to reduce the risk of your employer stock, please let us know.
– Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. No strategy assures success or protects against loss.
Stratos Wealth Partners, BWM Financial and LPL Financial do not provide tax advice or services.