Stock Awards, Part 1: Planning to Manage Tax and Risk
Equity or share-based compensation can be a significant source of wealth for many employees. However, among 86,000 participants in Morgan Stanley’s 2022 Annual Stock Plan Participant Survey, only 38% knew how to maximize the financial benefit of their stock awards.1 This article is part of a series on how to make the most of your equity compensation.
Stock awards can be a powerful way to incentivize employees. It gives them an owner’s perspective, so they approve and execute projects that add shareholder value and lets them participate directly in the value that is created.
Knowing the value of your stock awards and managing their impact on your financial future can be a big part of your overall financial plan. Two of the key planning items to consider are managing the tax ramifications of your stock awards and mitigating the risks that can arise. Here's a look at both issues.
Managing the taxes related to stock awards
An effective tax management plan can prevent you from having to pay unnecessary taxes and potentially reduce the tax bill related to your stock awards.
For example, with stock options, you have control over when you realize the income between the time they vest and when they expire. In my experience, an effective strategy is to match the timing of the income realization with years when your income is lower, or when you have more deductions. Without such a plan, you might end up paying taxes that could have been avoided if you had exercised the options at a different time.
Another potential way to reduce the tax burden caused by your stock awards is to make an 83(b) election. Section 83(b) in the Internal Revenue Code (IRC) grants individuals the option to pay tax on the fair market value of the stock award when it is granted, rather than in the future when the shares are received. Assuming the company’s stock price increases between the grant date and the date your shares vest or are exercised, you can reduce the total tax paid for the shares you receive.
However, there are some risks and caveats to this strategy. For one thing, if the company’s stock price falls between the grant date and the date your shares vest or are exercised, you will pay more tax than you would have if you hadn’t made the 83(b) election. The election is only possible if the stock is subject to a vesting schedule and the election forms are sent to the IRS and your employer within 30 days after the award is granted.2 And keep in mind that you must have enough cash on hand to prepay the taxes when you make the election.
Mitigating the risks associated with stock awards
As your stock awards vest, your overall financial health will increasingly depend on the performance of the company’s stock. This is known as concentration risk. In my experience, a good rule of thumb is to avoid having more than 5% to 10% of your investment portfolio concentrated in any single stock position.
Since you have no control over whether the company’s stock price increases or decreases, having a plan in place before the awards vest can help you manage this concentration risk appropriately, without having your decisions clouded by emotions or thinking of it as an all-or-nothing decision.
Instead, you can treat your ownership of company stock like any other investment decision. A common approach is to imagine you have cash to invest and ask yourself if you would invest it in the company’s stock. If so, how much would you be comfortable buying? Your answers to these questions may help you decide how much stock to keep and how much to sell in order to diversify your portfolio more broadly and reduce concentration risk.
Stock awards have the potential to generate significant wealth for employees. To make the most of them, we believe it is wise to work with tax and wealth advisors who can help develop strategies to reduce your tax burden, balance your potential for risk and reward, and increase the chances of achieving your long-term financial goals.
1 2022 Annual Stock Plan Participant Survey, Morgan Stanley
2 83(b) Election: Tax Strategy and When and Why to File, Investopedia
ABOUT THE AUTHOR
Corey Orthengren, MPA
Corey Orthengren is a member of our Financial Planning Team. Prior to joining RGT, he worked as a commercial credit analyst for Amarillo National Bank, a regional bank in Amarillo, Texas. In his position, Corey did the underwriting for many commercial and industrial loans the bank made.
Corey graduated from West Texas A&M University with a bachelor’s in finance and accounting and a Master of Professional Accounting. He has passed the CFA Level 1 exam and is currently in pursuit of a CPA license and CFP certification.
This information is for educational purposes and is not intended to provide, and should not be relied upon for, accounting, legal, tax, insurance, or investment advice. This does not constitute an offer to provide any services, nor a solicitation to purchase securities. The contents are not intended to be advice tailored to any particular person or situation. We believe the information provided is accurate and reliable, but do not warrant it as to completeness or accuracy. This information may include opinions or forecasts, including investment strategies and economic and market conditions; however, there is no guarantee that such opinions or forecasts will prove to be correct, and they also may change without notice. We encourage you to speak with a qualified professional regarding your scenario and the then-current applicable laws and rules.
Our clients must, in writing, advise us of personal, financial, or investment objective changes and any restrictions desired on our services so that we may re-evaluate any previous recommendations and adjust our advisory services as needed. For current clients, please advise us immediately if you are not receiving monthly account statements from your custodian. We encourage you to compare your custodial statements to any information we provide to you.