Equity Compensation: Understanding the Employee Benefit that Could Cost You Money

Equity compensation has the potential to create substantial and lasting wealth for employees. However, unlike your salary or a cash bonus, shares of company stock received as compensation never actually hit your bank account, making it much harder to take decisive action with this newly acquired asset. This can often lead to no action being taken at all. While inaction might not seem like a big deal, it’s one of many ways that equity compensation can lead to major financial setbacks if not managed appropriately.

Here are five ways you can lose money with equity-based compensation and tips for avoiding them.

1. Using company stock as an emergency fund

The purpose of an emergency fund is to help protect you in the event of an unexpected loss of income or large unforeseen expense. You might need this money tomorrow, so it’s important to make sure it’s there for you.

Funds used for this purpose should be held in cash, not bonds or stocks, and certainly not in a concentrated position of stock at the company you also rely on for income. Otherwise, you run the risk of having substantially less than expected to fall back on right when it is needed the most.

2. Holding excessive amounts of company stock

According to research conducted by J.P. Morgan in 2021, more than 40% of all stocks ever listed in the Russell 3000 between 1980 and 2020 suffered a catastrophic loss of 70% or more and never recovered.

The two sectors with the greatest percentage of companies experiencing this loss, both of which are no strangers to awarding equity compensation to employees, were energy (65%) and information technology (59%). If a loss such as this would be a major financial setback given the amount of company stock you currently hold, you probably have too much. Cover your bases first with an adequate cash reserve and a well-diversified portfolio of global stocks and bonds, then consider how company stock can fit into the equation.

3. Understanding the taxes on equity compensation

Navigating the complex landscape of equity-based compensation can be daunting, particularly when it comes to understanding the intricate web of tax rules and regulations accompanying such arrangements. With an array of equity compensation plans available, including employee stock purchase plans, restricted stock, non-qualified stock options, and incentive stock options, it’s crucial to grasp the distinct tax implications that apply to each.

Some factors to consider include the holding periods required to receive more favorable tax treatment, the timing of taxation and the degree to which you have control over it, the specific tax rates that will apply given your situation, and the type of equity compensation you have, and the amount of tax you’ll owe relative to any amounts withheld for taxes.

One of the most substantial pitfalls to watch out for comes with ISOs. Although ISOs are not subject to regular income taxes upon exercise, they are subject to the Alternative Minimum Tax. When not adequately planned for, the exercise of ISOs can lead to a tax bill that is many times higher than expected, which can potentially present a major cash flow problem when those taxes come due the following year.

4. Leaving money on the table when quitting your job

When transitioning away from your current employment, it’s important to be aware of potential missed opportunities that could inadvertently leave you financially shortchanged. This is especially pertinent when departing shortly before the vesting of additional grants, particularly if your equity compensation follows an annual or quarterly vesting schedule. Prematurely exiting in such scenarios could mean leaving valuable equity on the table, underscoring the importance of timing your departure thoughtfully.

Equally critical is the vigilance required around vested but unexercised stock options that expire within 60 to 90 days following termination. The divergence between the accelerated post-employment expiration date and the timelines detailed in your grant agreement and brokerage account statements can catch individuals off guard, leading to the forfeiture of valuable assets. To maximize the benefits of your equity-based compensation, you must pay careful attention to vesting dates and expiration dates (if applicable) and prevent unintended financial losses.

5. Letting tax implications drive investment decisions

Balancing investment decisions with tax implications demands a strategy that aligns with your overall financial objectives. While there can be advantageous tax considerations tied to holding onto company stock for a specific duration before selling, particularly for ESPP stock and shares acquired through ISOs, it’s crucial to maintain a broader perspective. Opting to retain a stock position solely to secure a 9% tax savings when its value subsequently plummets by 40% is not a desirable outcome — especially if those funds are needed for short-term goals.

The true measure of success lies in making choices that harmonize with your unique financial circumstances while minimizing tax burdens. Rather than allowing tax implications to dictate your investment strategy, it’s wiser to prioritize actions that align with your financial goals in a tax-efficient manner, ensuring a holistic and well-informed approach to wealth management.

Recognizing the nuanced challenges and potential pitfalls is paramount to safeguarding your financial well-being when offered equity in a company as compensation. A thoughtful, well-executed approach to equity compensation planning can help you harness its benefits while sidestepping potential setbacks, ensuring a more secure financial future.

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(Featured image by StartupStockPhotos via Pixabay)

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