How to Plan for Retirement with Equity Compensation

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 both for a business owner and as an employee.

Making automatic contributions to an employer-sponsored plan is the foundation of smart tax-advantaged retirement savings, and you want to be sure you utilize the opportunity. That being said, a retirement income plan from company 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.

Taking Care of the Basics

Retirement planning is about consistently putting a savings account that has the potential to grow on a tax deferred basis so that when you’re retiring, you have a big chunk saved for your retirement. It’s important to 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 or ESOP 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.

The 83(b) Election

If you have restricted stock, there is a way in which you can elect to have the stock be taxed at potentially, a more beneficial rate. Section 83b provides the chance for you to recognize the stock as W2 earnings in the year which you receive the stock. It would still be considered restricted stock, but the growth would be tax deferred until you’re eligible to exercise your options at a later date. Upon the sale of the restricted stock, rather than the tax treatment being short term capital gain (i.e. ordinary income), your 83b election would allow you to recognize the sale of the stock, but the taxation would be considered long term capital gain vs. short. This could prove advantageous from a tax perspective if the stock had a high amount of appreciation during the years you deferred it.

The catch is you have only 30 days to elect this option when you’ve received the stock so talk with your tax professional if you’re in a position like this.

Addressing Concentrated Stock Positions

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 likely 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 income needs in retirement. If this is the case, holding a higher concentration of company stock may be worth it for the potential increase in value. If the stock is the bulk of your retirement savings, you may want to think about ways to diversify your portfolio to help reduce the concentration risk.

If you’re an employer, a stock plan may help drive employee performance as you’re incentivizing your workforce to perform better. Not to mention, you’ll have an advantage on your competitors as you’ll be offering a plan that many other organizations in your industry may not be considering.

Decide Where the Equity Compensation Fits into Your Retirement Income Picture

Depending on how many shares you hold and what their value is, one of the best uses of equity compensation could be to fund an early retirement. Using the equity of your stock during your early retirement years may help you make ends meet by creating a potential income stream without paying the penalty for early withdrawals from a retirement plan. It might also help you delay social security to maximize your full retirement age (FRA) benefits.

Using the stock as your sole source of income can also be potentially tax efficient. Exercising your options and selling your stock can result in taxation as both earned income and capital gains, and you could be subject to the alternative minimum tax. Having a lower income in the years in which you are selling stock may result in lower taxes.

Getting Close to Retirement

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 and you may have to forfeit any unvested shares when you retire. Depending on the value of those shares, you may want to delay your retirement past key vesting dates.

Once your employment is officially “terminated” and you’re retired, 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.

Weighing Taxes and Price Volatility

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 for income, reduced volatility and limiting a big tax bill will require careful planning.

Conclusion

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 talk with a financial planner who is well versed in equity compensation so together you can come up with a strategy for both your working and retirement years.