Stock options and restricted stock units (RSUs) are becoming more common as part of a total compensation package. But there are differences between saving for retirement from salary and incorporating stock into a retirement plan.
Making automatic contributions to an employer-sponsored plan is the foundation of tax-advantaged retirement savings, and you want to be sure you take full advantage. But once you set it up, it happens without you thinking about it. Creating a retirement income plan from stock requires more proactive and consistent planning. It may also fit into your retirement income planning in a different place than traditional savings.
Depending on where you are in your career, you may have decades to exercise options and set up a plan to save consistently. Or you may be close enough that you’ll need to carefully plan your retirement date to vest as much as possible before employment termination.
Retirement planning is about consistently putting away as much you can and getting the most benefit out of what you are saving. Take the time to understand the contribution limits for your 401(k) plan, if you get a matching contribution from your employer, and if your company offers an employee stock purchase plan. These are all ways to save that you can revisit annually, to ensure that as your salary increases, your savings contributions go up along with it.
If retirement is some years away and you are exercising options and selling your stock, you should also be saving a portion of the proceeds in an IRA or taxable account with a long-term time horizon. Depending on if your company is public or what the timeline for listing is, the backdoor Roth IRA can also be a good solution for creating tax-advantaged retirement savings from an equity position.
If you have stock options and an employee stock purchase plan, you may end up with an overconcentration in your company’s stock. Since your employer is also the main source of your income, this can have an outsized impact if anything goes wrong. While a general rule of thumb is to hold only 10-15% of your portfolio in a single stock, it is different for everyone and depends on your situation.
You may have built up a large enough retirement balance in your 401(k) and after-tax IRA accounts to meet your needs in retirement. If this is the case, holding a higher concentration of company stock and accepting the volatility may be worth it for the potential price increase. If the stock is the bulk of your retirement savings, you may want to think about ways to diversify your portfolio.
Depending on how many shares you hold and their value, one of the best uses of equity compensation is to fund an early retirement. If you can realize enough to live on, equity can allow you to retire early and create an income stream without paying the penalty for early withdrawals from a retirement plan. It can also help you delay social security to maximize the annual benefit.
Using the stock as your sole source of income can be tax efficient. Exercising your options and selling your stock can result in taxation as both earned income and capital gains, and you can be subject to the alternative minimum tax. Having a lower income in the years in which you are selling stock can result in lower taxes.
As retirement gets closer to reality, assessing the value of your shares is important to understanding your total retirement income picture. Your vesting schedule will have details of your rights to the stock award. You will likely have both vested and unvested shares, and once you retire, you may have to forfeit any unvested shares. Depending on the value of those shares, you may want to delay your retirement past key vesting dates.
Once your employment is officially terminated upon retirement, something called the “post-termination exercise clock” starts counting down. A common provision is for 90 days post-termination to exercise vested employee stock options.
If you use your equity compensation to fund early retirement, you’ll need to sell your shares. Taxes will be due, and you’ll need a plan to balance when you sell so that you can minimize taxes and take advantage of lower-income in retirement. However, you’ll still be exposed to the price volatility of the stock. Creating a plan that can produce income, reduce volatility and not generate a big tax bill will require careful planning.
Equity compensation is increasingly common and can add significantly to your personal wealth. It can represent the risk you take and the commitment you make when joining a startup, and it can result in larger payoffs than traditional compensation. However, it is risky and more complicated than traditional retirement savings. The best plan is to maximize both and let them work together so you can retire on your schedule and fund the life you choose in retirement.
Collabria Capital, Inc. is a San Francisco-Bay Area fee-only fiduciary financial planner& investment manager providing wealth management services to clients locally and virtually throughout the US.
Paul Saad, Co-Founder at Collabria Capital, Inc, is a CERTIFIEDFINANCIAL PLANNER™ (CFP®) focusing on comprehensive financial planning, personalized investment management, and equity/variable compensation.
The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.
• 3 different types of options
• How to know when to sell
• Terms to know
• How to reduce risk