In the Roald Dahl classic, Charlie & The Chocolate Factory, there is a moment of glee and unending possibility when protagonist Charlie Bucket unwraps a bar of chocolate and finds a golden ticket hidden underneath.
This feeling of endless opportunity and joy rarely happens for us as adults. Yet, for one segment of the population, there is one moment that might feel like they found a golden ticket: when restricted stock is granted as part of their compensation package.
In the world of equity compensation, restricted stock is far more straightforward than stock options. Restricted stock is simply shares issued to an employee that cannot be transferred to them until certain conditions have been met. These conditions can be time- or performance-based.
Corporate benefit groups appreciate the ease of restricted stock as well. Since the early aughts, a significant percentage of publicly traded corporations have moved from issuing stock options to granting restricted stock. Employers hope that they are providing great wealth-building opportunities with these grants. In fact, in Charles Schwab’s 2017 Equity Compensation Plan Participant Survey, the average value of the participants’ stock compensation was $72,245 and approximately two-thirds of the participants were fully vested.
But like Charlie’s journey into the Chocolate Factory, the path to converting restricted stock into true wealth can be a winding one. While restricted stock creates great upside potential, if employees do not know how to manage the risks, they might not receive the full benefits.
Unprepared for the Tax Challenges
One of the biggest issues that Schwab found with its survey is that 50% of employees want more advice on the tax implications of restricted stock.
“They understand the basic concepts of these grants because they are relatively straight forward. The employee receives a specified number of company stock shares when the restrictions lapse at a future date,” says Bill Dillhoefer, CEO of Net Worth Strategies Inc, a provider of professional equity compensation risk analysis and tax planning tools. “However, employees can be surprised by the tax impact of vesting.”
As it is ordinary income, restricted stock is treated for tax withholding similarly to bonus withholding. Corporations are required to use statutory withholding rates for both federal and state purposes. For employees whose cumulative compensation is less than $1 million, the employer is only required to withhold for federal purposes at a 22% rate. This can create a challenge for employees who are in a higher tax bracket.
Further each state sets its own statutory rates. For instance, in California, the majority of taxpayers are at the 9.3% bracket, yet these awards are withheld at 10.23%
At tax time, most employees find themselves in an odd tax quandary: while they are breakeven or even in a small refund for state purposes, they have a federal balance due. It is a source of frustration for many, especially if the proceeds from the shares have already been spent.
The tax planning for restricted stock should be as straightforward as these awards themselves. While it is always prudent to engage a tax professional, employees can do a simple analysis by taking their gross award and multiplying it by their tax rate.
For instance, if an employee’s grant of 1,000 shares vests at a price of $10 a share, the gross award is $10,000. For federal purposes, the company will do share withholding at a rate of 22% or $2,200. But if the employee is in the 32% bracket, then a rough estimate of their liability is really $3,200. While this is just a rough estimate, it gives the employee the power to set aside the right amount for their tax bill. This back of the envelope planning allows an employee to be in control of their tax situation.
Hold or Sell
Once the stock vests and the net shares are deposited into the employee’s brokerage account, the recipient must decide what to do next. Often employees feel there are only two choices: sell immediately or hold a concentration position. Schwab found that half the employees surveyed were concerned about making a mistake when they sell their company equity. It clearly is a decision that causes significant stress.
There are benefits and risks to both courses of actions. For those who sell immediately, they mitigate single stock volatility risk and have liquidity to diversify. But those who hold on to the shares are hoping for upside growth.
“Both approaches are short sighted, inefficient and risky,” says Dillhoefer.
According to Dillhoefer, that is where a third approach comes in: selling shares systematically. His firm’s StockOpter tool can help set parameters on when the stock is sold and the proceeds move into a diversified portfolio. For instance, when modelled out, an employee might decide they will sell 10% of their holdings when the stock reaches certain prices and move the holdings into their investment account.
“Advisors using equity compensation analysis software can model company share diversification strategies that address financial goals and reduce risk,” explains Dillhoefer. “Using basic tax and growth rate assumptions, it illustrates how a small rate of diversification can reduce the risk of a concentrated company stock position over time.”
Don’t Let Budget Creep Erode Your Wealth Building
But maximizing restricted stock awards is not all taxes and investment strategies. Rather, employees need to add one last component to the mix: budgeting. By getting a strong grasp on living expenses, an employee can focus on using salary compensation to cover regular living expenses. When the restricted stock event occurs, the wealth building can really begin.
The proceeds should be earmarked for different buckets of the employee’s financial plan. For example, an employee might allocate the proceeds to be split between paying the remaining tax due, contributing to their child’s 529 plan and adding to their investment account. These strategic allocations enable the employee to make progress toward financial goals versus letting the proceeds simply go to cash flow.
Having a Strategy is the Best Way to Go
Receiving restricted stock can be like being a kid in a candy shop. But without the right approach to tax, investment and spending, it becomes a lost wealth-building opportunity. If you capture and maximize the situation, it will ensure that your golden ticket isn’t wasted.
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