By Adrian Colarusso, CFA, CFP®
July 25, 2023
We are working with a growing number of clients who earn company stock as part of their compensation package.
Last year I wrote “The Sevens Sins of Stock Compensation”, one of my most-viewed articles on LinkedIn. Matt and I adapted that newsletter into a presentation to Wharton MBA students this past spring.
Stock comp provides a rich tapestry for our work.
At its core, the name of the game is to navigate the relationship between taxes and risk, whose interplay creates a wide range of potential wealth outcomes.
Those of you who earn stock compensation and feel uncertain or overwhelmed by the stakes of your decisions – or even those who all-too-cavalierly treat their stock comp as “gravy” and nothing to fret over – might benefit from a conversation with us.
Part 1: Restricted Stock Units (RSUs) at a public company
This is the most straightforward and common scenario, yet we have had clients play this in a variety of ways.
Public company stock is generally liquid and priced fairly. Folks with private company shares or options must contend with much more uncertainty (not to mention tax complexities). More on stock from start-ups or private companies in part 2.
RSUs are taxed as ordinary income at market value when they vest. After vesting, the shares then begin to accrue capital gains tax liability (if the share price rises) on top of the income tax liability.
So the fundamental question at the time of an RSU vest is “if my company paid me this in cash, would I turn around and buy my company stock with it?” If the answer is “no”, but you hold on anyway, you might be suffering from endowment bias.
Our off-the-shelf recommendation on public RSUs is to automatically sell shares for tax withholding (and work with a tax professional to calibrate your W-4), then automatically sell the rest of your shares to re-invest in a diversified portfolio. After all, you have plenty of exposure to your employer through your paycheck and bonus.
Boring and cliché, I know.
We have several clients who came to us not having followed this rule of thumb. Their outcomes had ranged from dreadfully disastrous to outrageously enriching.
Our experience and reams of research suggests that concentrating wealth in a single publicly traded stock is much more risky than it is beneficial, despite the relatively few but loud counterexamples we see among those for whom it worked out.
Meet Austin, the tech exec
We have one client, Austin (name changed), whose investment results were in the middle of that spectrum. He is a rising star executive at a publicly traded software company, and he has conviction that his team can beat analyst expectations and cause his stock to outperform.
Accordingly, he had sold very little of his vested RSUs when he started working with us, and had plenty more coming down the pike after his recent promotion.
So, our focus with Austin is to properly calibrate the size of his bet in his company stock (as in, bring it down, but not out of his portfolio), and then manage the rest of his investments with an eye toward this concentrated risk.
He used to turn a blind eye to his unvested stock, since he didn’t consider it “his” yet. This caused him to hang onto more of his vested stock than was ideal, until we got him to account for his unvested shares more properly.
One of the first things we had to convince him of is that there’s no reason to be sad if his stock goes up after he sells the vested shares, because he’ll still benefit from the appreciation in his unvested shares. This should lower his “risk of regret.”
Yes, plenty of you job hop. And in this environment of layoffs, reaching a vesting milestone is not guaranteed. But if you have no plans to leave your company (he doesn’t), and you are a high-performer (he is), then there’s a good chance that the gains will be yours.
I showed him this table of his upcoming vests over the next four years, assigning each date a probability that he is still at the company (amounts changed):
He agreed that my probabilities were roughly accurate. The insight here is that, instead of treating unvested stock as an all-or-nothing proposition to your wealth picture, let’s have some nuance in our accounting.
As in: “hey, for all intents and purposes, you have $67k in stock that you’ll be happy about if it goes up. Now let’s take some risk off the table and sell some of your vested shares.”
Untying the tax knot
After convincing Austin he had plenty of exposure to the upside of his stock, it was time to reduce it from his wealth picture. This meant selling vested shares with an eye on taxes.
As we’ve seen with many clients, especially after the bear market of 2022, some of Austin’s shares were at a loss and some were at a gain.
A good starting point is to determine how much cash you can raise tax-neutrally by matching gains with losses. You’ll want to look at the lot-level cost basis information in the account where your stock is held.
We also worked with Austin to open a Donor Advised Fund, where we placed his most appreciated shares. He enjoyed an income tax write-off for the current value of the stock, and the capital gains tax liability was washed away. For someone who itemizes deductions and donates money to charity anyway, it was a smart move.
After raising as much cash as we could tax-neutrally and donating the most tax-laden shares, it was time to look forward.
Let’s not insider trade now
A 10b5-1 plan helps executives sell their shares with less risk of insider trading allegations from the SEC. Austin wanted to craft a plan that would allow him to cash in on his shares as they vested, but not if the price is too low.
The third-party custodians of his stock compensation will now automatically sell shares (or hold them) according to the plan we drew up, which keys off the market price after the stock vests. If the price is high, he’ll sell more, and if it’s low, he’ll sell less (but still some!). Even if he has material non-public information as a corporate insider, the SEC shouldn’t give him a hard time about his selling behavior since he pre-defined his plan.
This is a refinement of our off-the-shelf recommendation to sell all shares immediately at time of vest. Since we don’t have any strong views on his stock, we must defer to Austin’s investment thesis. Our job is just to keep the risk within tolerance, and talk him back from more extreme strategies that could harm his wealth permanently if they work against him.
And if the stock performs, he’ll have capital gains tax liability in his company stock…
Where Direct Indexing comes in
We previously wrote about Direct Indexing, highlighting two key benefits over ETF investing: 1) the ability to customize for unique client circumstances and 2) more granular tax-loss harvesting opportunities.
First, Austin’s diversified portfolio needn’t include shares of his company – since he has plenty of those, so we can delete that stock when we direct index for him. Furthermore, he already has plenty of technology sector exposure through his employer stock, so his version of a diversified portfolio has a built-in underweight to tech.
This customized posturing helps lower the risk of his wealth portfolio, and may even enhance returns if his company or industry falters.
Second, direct indexing allows us to track a diversified portfolio’s performance in aggregate, while tactically selling losing stocks within the index on a regular basis. This stockpiles capital losses, which we can apply toward capital gains in his company stock. He’ll be able to carry forward those losses from year to year as an “asset” on his tax return.
Direct indexing effectively transmutes the tax liability from a concentrated, risky single stock to a much broader basket of diversified stocks. So, when Austin is ready to part with (hopefully) appreciated company shares a little while after they vest, we should be able to wash away at least some of the tax liability.
Just the tip of the iceberg
Our work with Austin extends well beyond how he manages his stock compensation. There are many moving parts in his family’s wealth picture, and we feel privileged and honored to help them point their wealth toward its highest purpose.
If you or your spouse have stock compensation questions as part of broader wealth planning needs, we hope you’ll set up some time to explore what it’s like to work with Target Rock.
Next time, I’ll write to those of you who have options at a start-up.