Since the mid-1990’s, the internet and the digital age have transformed the way we live. Technology has been the foundation for industry disruption and as a result, there continues to be an opportunity for technology companies to rise from a small start-up to a full-fledged public company in a matter of years. With the sudden disruption and subsequent rise, it creates wealth for many of the hardworking employees that got it there. For people awarded with stock options or some form of equity compensation, this can create quite the “problem”. Obviously, not in the sense of this sudden or budding wealth, but more so answering the question now what? What risks arise when holding a concentrated stock position? How do I minimize taxes? In this article, I’ll explore these questions, the “risks” they pose, and more.
But first a quick rant, how awesome is it that hard-working employees can be awarded ownership in businesses? I think it’s sometimes forgotten that equity rewards such as RSU’s, employer stock purchase plans, or stock options, all award employees or executives of a company actual ownership in the company. A stock signifies you’re an owner! Don’t forget that simple fact! It makes investing in quality, fundamentally sound companies for the long-term that much easier while filtering out the “noise”. Yet, it’s not easy to sell your companies stock that you’ve directly helped take public or reach record market capitalizations. Becoming emotionally, yet irrationally attached to your company stock is a normal reaction. However, when managing investments, we have to take emotions out of the equation at look at it from a rational perspective as best we can. Moving on…
Managing Sudden or Budding Wealth in One Stock
Whether you’ve had the opportunity to exercise your stock options, participate in your ESPP, or accumulated RSU’s over the years – without taking any action, you’ve likely accumulated a large amount of company stock relative to your OVERALL portfolio. Again, while this is a great problem to have, from a rational perspective there are a few things to consider. 1) What are the risks of holding a concentrated stock position? 2) How am I managing my taxes?
Risks of Holding a Concentrated Stock Position
Concentrated stock is common among the tech industry because they often compensate employees with equity, whether that’s through stock options, RSU’s, or ESPPs to name a few. Over time, the longer you’re employed at the company, the more stock you’ll likely accumulate. Couple that with a rising stock price, and before you know it, your company stock might be 50% or more of your overall portfolio.
You’re probably wondering “how is this a risk, especially if the stock price has been skyrocketing?” When it comes to investing it’s important to understand that a company’s past performance has nothing to do with how it will perform in the future. There could be a botched product launch, PR disaster, or even worse, a fundamental problem in the business, setting itself up for disruption by another tech company! When you put all your eggs in one basket, you take on all the risk that is posed by that basket. If you spread your eggs to different baskets, you’re greatly reducing the risk all your eggs will break by a failing basket.
The key to diversification is understanding these risks. Particular risks can be “diversified” away. From an academic perspective, these are known as unsystematic risks. If you’ve ever taken an economics class, you’ve probably heard of the efficient frontier. When it comes to investing, diversification attempts to reach that efficient frontier. The closer the better, because it means you’re maximizing return given a particular amount of risk. By diversifying away all unsystematic risk, you’ll essentially reach that efficient frontier.
You might worry your potential return could be lessened by diversifying since your companies stock has performed extremely well and as a result built you quite a significant amount of wealth. However, diversifying aims to reduce risk, not necessarily return. Particular risks are unnecessary and they’re in abundance when holding a concentrated stock position.
Minimizing Taxes With a Concentrated Stock Position
With stock options, depending upon whether they’re non-qualified or qualified, you had to pay income tax on the “bargain element” or the difference between the exercise price and market price, in addition to actually determining when to exercise. With RSU’s you pay income tax in the year the stock becomes vested. Lastly, with ESPP’s you’re buying company stock using after-tax dollars. All these tax attributes are unavoidable. However, it’s what we choose to do AFTER we’ve received the stock that we can control how we manage the tax consequences.
There remains a balancing act when considering how much stock to diversify and how much to keep. Not only to reduce risk but to “spread out” the tax burden over several years.
For example, let’s imagine you have $200,000 worth of your tech companies stock, which makes up over 2/3 of your overall portfolio, meaning you have $300,000 in total investable assets. That additional $100,000 could include your 401(k), IRA’s, or a taxable account. This would qualify as a concentrated stock because it makes up the majority of your portfolio and all your eggs are almost in one basket! Yet, of that $200,000 in stock, $180,000 is attributable to capital gains. Meaning, you’re eventually on the hook to pay taxes on the gains, it’s just a matter of when.
Managing Capital Gains and Marginal Tax Brackets
First, a refresher on capital gains tax. Stock held for less than 1 year and sold, are subject to taxes at your ordinary income tax bracket. Stock held for greater than 1 year and sold, are subject to either a 0,15 or 20% tax on the gain determined by your income tax bracket. ESPP’s are a little trickier, they only allow long-term capital gain treatment if shares are held for more than a year after the purchase date and more than two years after the beginning of the offering period.
Now, two things to consider – reducing risk, and how quickly to offload capital gains tax. If we sold all the company stock that’d catapult you into higher tax brackets but also allow for diversification. If we did nothing, a concentrated risk would remain, but nothing would be owed additionally in taxes.
Instead, make an educated “guesstimate” of how much capital gains can be realized by selling your company stock in order to get to the fringe of the next tax bracket. For example, if you’re making $160,000 in 2018, you’re subject to the 32% marginal tax bracket. In order to “max out” that tax bracket you would sell $40,000 worth of your companies concentrated stock and diversify into other investments. The goal is to get as close to the next tax-bracket as possible without reaching it. Remember, capital gains tax will be owed on the $40,000, but the $40,000 is added to your AGI (aggregate gross income) which is used to determine your marginal tax bracket. The marginal tax bracket is used to determine how much you pay on earned income. If you were to go into a higher tax bracket, you would owe more on your earned income. Get the point? While it doesn’t directly impact how much you owe on the $40,000, pushing into the next highest tax bracket would still increase your tax liability.
While this doesn’t fully solve the concentrated stock issue, it does make progress. The same strategy would be pursued in the following years until the stock allocation was less and less concentrated.
Charitable Donations to Reduce Taxes
Lastly, if you’re charitably inclined, there are ways to offload highly concentrated, appreciated stock to charitable organizations that also reduce your tax burden. A common tool used is a donor-advised fund. The donor-advised fund allows you to make a contribution of stock (preferably highly appreciated or concentrated stock) to charity. You receive a tax benefit in the year you make the contribution, however, you can actually allow the stock to remain or diversify it into other investments within the donor-advised fund. Meaning, you can wait to make a grant towards a charity until later years. Donor-advised funds are great for involving family, or kids, and building a legacy of giving.
It’s not to say holding a concentrated stock is always wrong, but it’s important you remain aware of the risks and try to remove emotion from the equation. Oftentimes, especially because it’s your place of work and you directly contribute to the company, it can be hard to do so. That’s where an unattached third party, such as a financial planner can help talk you through the risks, advantages of diversification, and managing tax consequences.
The Bottom Line
Calling a concentrated position in your companies stock a “problem” is obviously a bit misleading. It’s more so comes down to maximizing the benefit than managing the problem. Stock options, RSU’s, and ESPP’s are all great benefits to have and common in the technology industry. Working with people in this industry I’ve become familiar with how to maximize their benefits, navigate tax planning for each individual situation, and provide investment perspective from a holistic standpoint. If you’re unsure whether you’re managing your equity compensation to it’s fullest potential or need help articulating what you actually want your sudden wealth to be used for, schedule a free consultation with us today.
Levi Sanchez is a CERTIFIED FINANCIAL PLANNER™, BEHAVIORAL FINANCIAL ADVISOR™ and Co-Founder of Millennial Wealth, a fee-only financial planning firm for young professionals and tech industry employees. He is an avid sports fan, personal finance and investing geek, and enjoys a great TV show or movie. His mission is to help educate his generation about better money habits and provide financial planning services to those who want to start planning for their future today!