Planning for retirement is a life-long process
While many recipients of equity compensation intend to use it to boost their savings and lifestyles, I find that many of them do not see it in the bigger picture of retirement savings and post-retirement withdrawal plans. Your employee stock grants can also affect decisions related to a 401(k), non-qualified deferred compensation, ROTH or an IRA.
Start by Taking a Disciplined Approach to Contributions to and the Management of Your 401(k) or Other Company-sponsored Retirement Plan
Make it a goal to maximize your contributions to the tax-deferred plan provided by your employer. For 2024, the elective deferral (contribution) limit for employees who participate in 401(k) is $23,000. If you are over age 50 you can also make a $7,500 catch-up contribution. Your employer may match all or a portion of your contributions. Regularly maximizing your saving in this manner is the first step in building retirement wealth.
The second step is to manage your plan diligently using a systematic approach to risk assessment and your investment time horizon. A diversified portfolio that is allocated across numerous market sectors may likely to be less volatile and provide a more dependable rate of return than whatever default option your employer has chosen for your plan. Work with a qualified financial professional on developing a strategy for your unique situation. The strategy should include a review and re-balancing of the portfolio of investment funds, at regular intervals.
Company Stock Is An Important Part Of Your Portfolio
Considering a employee stock plan recipient’s net worth, age, and company stock plan holdings, I start the financial planning process by explaining that a single grant of an employee stock option is not by itself a long-term investment. Most option grants have, at most, a 10-year term, and any one grant probably won’t make you rich. Likewise, a single restricted stock grant won’t make a big difference either. But you should still think of them as potentially important parts of your investment portfolio, along with other stocks, mutual funds, and ETFs you own.
After all, when your company’s stock rises, employee stock options may provide you with upside leverage far beyond that of most other investments. Though rare, a single grant can grow to become a significant part of your wealth. Restricted stock can provide tax-favored capital appreciation (if you make a Section 83(b) election at grant), and perhaps dividends, and it is certain to have some value at vesting, unless your company’s stock drops to zero.
A series of employee stock option grants over a span of years provides even more leverage, and begins to look a lot more like a portfolio. When that portfolio begins to have various grant types, multiple exercise prices, graduated vesting schedules, and all the other characteristics that your company’s compensation consultants have dreamed up, that complexity may become overwhelming.
Employee stock plan participants often ask me to help them fashion a tactical financial-planning strategy designed not only to maximize the value of their stock compensation but also to coordinate with a 401(k) retirement plan (where many of them have company stock as the result of the employer match of their contributions). If you work for a public company, it’s very likely that you too are “surrounded” by its stock. You may be comfortable with your degree of concentration in company stock now, but your feelings may change as you begin to ponder both your tolerance for risk and the need for income in retirement.
Know how much you are concentrated in your company’s stock.
Get out all your benefit statements. These include the statement from the brokerage firm or transfer agent that may administer your employee stock option, restricted stock, and/or employee stock purchase plan. These also include your 401(k) statement, which may be with another firm. If you are holding company stock in a personal brokerage account, including retirement accounts such as IRAs, get that out too. Add up the value of all the company stock from all these sources. Keep track of the number.
Now, add up the non-company other stock holdings from your 401(k), savings account, brokerage account, mutual funds, etc. (don’t include the value of the equity in your home). Add the two numbers. The sum is your liquid net worth. Divide the company stock value by the total. The result is the percentage your company stock represents in your liquid net worth.
Whole books have been written about what this percentage “should” be. Right now we are interested only in knowing what it is. A retiree probably shouldn’t have more than 10%–15% of net worth in any one stock (even the stock of that great American company from which you may soon retire). To review concentration and diversification, including a tally sheet to use, see my blog post “Company Stock Diversification”.
Set a goal for the amount of income you’ll need in retirement.
Retirement, for most people, will require a substantial amount of savings beyond your Social Security payments. For people who have substantial earned income past age 65, delaying Social Security is often a smart option because the later you take your benefits, the larger your payment will be (check your Annual Social Security statement with your personal benefits estimate from the Social Security Administration). Your benefits increase about 8% per year while you delay taking them, up to the age of 70. Then your payment remains level. This isn’t a “free lunch”. According to the way the actuarial calculations work, if you live to your full life expectancy, you will receive the same total amount whether you take benefits early, at full retirement, or later. When you get it later, your checks are just bigger but you get fewer of them.
There is no magic number as a goal. But you’ll probably want to have accumulated enough so that you can at least live a lifestyle similar to the one you’ve gotten used to while you were working. A 2008 study of executives "Second Act" jobs by the Wall Street Journal revealed that many of them have some pretty expensive post-employment pastimes in mind. Whatever amount you decide is enough, you need to consider that inflation will probably eat away at the purchasing power of your savings over time and make it more expensive to live in the world of 20, 30, or 50 years from now. You never know how much inflation will be, but a conservative assumption can be drawn from the past. Inflation since 1945 has averaged about 3% per year. Some years and several relatively short periods have been substantially better or worse.
Let’s pretend you live comfortably today on $250,000 per year and you think that, given your plans for the things you’d like to do when you don’t have to work any longer, $200,000 per year would adequately meet your needs. If we assume that you don’t want to significantly deplete your portfolio’s principal and that marginal tax rates will be about the same when you retire as they are today (this may be a big assumption), you’ll need a portfolio of about $7.14 million returning 4%, after tax, to produce the income you want.
Seem like a lot? Wait: we haven’t yet figured inflation on your cost of living! At a 3% inflation rate, the cost of living will double in 24 years. What happens if you live to be 100? It’s a good bet that you’ll need to either withdraw some of your principal or get a higher return on investment each year to keep up with a rising cost of living. This means that some portion of the assets you retire with will need to be invested with growth in mind. Balancing growth and income isn’t easy, but I suggest that you may want as much as 60% of your holdings invested in some sort of conservative growth strategy, even after you retire.
Don’t necessarily wait until retirement (or even expiration) to exercise all your employee stock options. Eventual retirement is a goal of almost every employee. You should think about it before you reach retirement age. Prudent financial planning requires that you have a strategy for your employee stock options. While stock prices rise over time and the value of employee stock options grows from leverage that compounds the increase in value, stocks don’t go straight up. A properly done tactical employee stock options analysis can illustrate the effect on your stock option grants of, say, a 10% rise or a 20% fall in your company stock.
Restricted stock does not get hurt as much in down or flat markets, making it more attractive as you near retirement if you’re risk-averse and focused on the preservation of your portfolio. When you expect to receive more employee stock option grants over time, as you move to within 10 years of your potential retirement, you should consider accelerating the pace of exercising/selling the older stock options and those that are most in the money. You would use the money for retirement savings or for important or necessary purchases so that the consequences of financing them wouldn’t linger into retirement.
Despite the tremendous leverage afforded by Employee stock options over the long term, your company’s stock price may sometimes rise rapidly, making it wise to take profits from deep-in-the-money options. A windfall from employee stock options can be thought of like a big bonus or paycheck that you don’t want to waste. You shouldn’t avoid the profit, even though you have to pay taxes on the exercise and sale of the option. A house, a car, college tuition payments: using employee stock options to finance any of these is better than using a loan, especially if the loan’s interest payments would stretch into retirement.
Most people know, moreover, what happened to employees of Enron and WorldCom who mistakenly believed that their stock could do nothing but go up. However, volatility has also hit employees at respected companies. At some, retirement or early-retirement plans have needed to be modified after ordinary market forces pushed their stock down 30%, 40%, and even 50% in a span of a few weeks. Even employees of long-revered financial firms, some in business for over 100 years, have discovered that they are not too big to fail. We hear that a surprising number of Lehman Brothers employees had 100% of their retirement assets in company stock. Make sure your advisor clearly understands your tolerance for risk, and don’t be afraid to take profits. This leads to my next important thing to consider with your proceeds.
Begin to build a safe income portfolio as soon as you can.
When you retire, you’ll have income from three primary sources: Social Security, your retirement plan, and savings. If you choose to work in retirement, there are Social Security income limits that may affect your benefits. Even if you don’t work, significant income from savings and retirement plans will have an impact on the taxability of up to 85% your Social Security payments.
No financial planning advice is right for everyone but many employee stock plan participants who are doing retirement income planning would be well advised begin building a portfolio made up of a mixture of investment grade bonds and high quality, dividend-paying stocks with a portion of the proceeds as they diversify their company stock holdings by selling the shares from stock options and the vesting of any restricted stock. Since bonds tend to fluctuate less in price than stocks and dividends tend to rise over time, together they make a sensible portfolio for people who want to receive a rising income (from the stocks) and who want to reduce risk (because the bonds generally fluctuate in price very little over their term). Someone who is 65 years old may want to have as much as 40% of all holdings in high-rated fixed-income securities.
Understand what happens to vesting when you retire.
Be sure you know your company's post-termination exercise rules. Most company plans provide retirees with favorable terms for the vesting of their retirement plans, and for their employee stock options and restricted stock when they quit working. Sometimes the advent of normal retirement accelerates the vesting of company matched stock in your 401(k) and the vesting of stock options and restricted stock, or lets them continue vesting for their full term. Become familiar with the age (and perhaps also years of work at your company) that may trigger special provisions for “retirement” and for “early retirement” (if you’re considering this). Do not assume the definition is the same for all company benefit plans. Few things are financially sadder than discovering after you left that by working only a little longer you would have triggered better treatment for your employee stock grants.
The retirement provisions in your employee stock plan may also generate the impetus to speed your diversification strategy or give you the flexibility to wait out a market downturn. In some cases you may be forced to hasten your diversification, because the post-termination exercise periods at your company may treat retirees just like anyone else who separates from service. This may mean that you have only 60 or 90 days to exercise your stock options after you stop working (even options that are accelerating at retirement). It is important for you to know what the plan and your grant agreement state about the acceleration in vesting for all your outstanding stock grants, the period you have for exercising the options, and any impact of doing consulting or other work for companies in your industry (e.g. forfeiture of employee stock options).
If, when you retire, you are forced by the terms of your stock option plan to exercise all of your non-qualified stock options (NQSOs) within 90 days (could be longer or shorter), it would probably be wise to sell all the stock associated with that exercise, regardless of how you may feel (or speculate) about the potential for future appreciation. Because NQSOs are taxed on the spread at exercise, holding the shares is the same as buying the net amount of shares you could acquire with the profit built into your options.
Remember that when you sell stock, the general laws against insider trading always apply. Therefore, wait until any confidential information you know is fully disclosed and absorbed by the market.
If you feel you must hold some of your company’s stock in retirement, consider holding the distributed shares from your 401(k) to take advantage of the Net Unrealized Appreciation (NUA) rules explained below. The number of companies that include their stock in 401(k) plans continues to fall. According to Vanguard "...between December 2005 and June 2020, the number of defined contribution (DC) retirement plans that offer company stock fell by 36% and the number of plan participants investing in company stock fell by nearly two-thirds. The number of participants with concentrated holdings declined by nearly three-quarters—from 14% of all participants to only 4%. Over that period, half of organizations that offered company stock funds either closed or liquidated their company stock fund."
But let's consider stock you might have in your 401(k), anyway. Let’s say you are 35 and make $100,000 a year. Let’s also assume you fully fund a 401(k) with a portion of that income. This means that in 2024 you can save a maximum of $23,000 in your 401(k) plan. (Those aged 50 and over can contribute an additional $7,500 per year.) Let’s also assume that the allowed contribution amount rises by $500 per year, that your income grows at 5% per year, and that your employer matches the first 3% of your contribution with company stock.
On these assumptions, between now and age 65 you will contribute over $750,000 to your 401(k). This puts you far ahead of the average worker. According to the 2022 Federal Reserve Board’s Survey Of Consumer Finances, only two thirds of US households in 2022 even had a retirement account.
Between now and retirement, your employer’s match of 3% of your contribution will add up to over $25,000 in company stock in your 401(k). Employers have cut back dramatically on funding defined benefit pension plans managed by the company in favor of defined contribution plans (like 401(k) plans) to which they can contribute cash or company stock. Defined contribution plans are managed by the plan participant (i.e. you). If your company stock rises by 8% per year, this portion of your retirement account will be worth more than $350,000 when you are 55 (for more suggestions about 401(k) plans, see the related points below).
Read your 401(k) plan’s guidelines for information about diversifying out of company stock. Many company-sponsored plans have been amended in the past several years to allow employees to more quickly diversify the company stock used to match contributions that the employees themselves make. These diversification plans are usually coordinated with the company’s trading windows and limit the amount of stock that participants can divest at one time. When you base decisions about diversifying in your 401(k) on your concentration in company stock, remember to also consider the stock options and restricted stock that are expected to vest.
Understand net unrealized appreciation (NUA).
Distributions from your 401(k) are normally taxed at ordinary income rates according to their value at withdrawal. But all that stock in your 401(k) is eligible for special tax treatment that you should understand before you begin to diversify and before you do a post-retirement rollover.
NUA is the appreciation embedded in your retirement plan from all that company stock which was contributed by your company at lower prices than today’s. When contributed, that value is called the basis. The difference between the basis and the current market value is eligible to be treated as a capital gain if you handle its distribution from your plan correctly. If you sell the stock in your 401(k) before you roll it out of (distribute it from) the plan—as your financial advisor may recommend, or you may consider, to avoid a stockbroker’s commissions—then the basis is wiped out. If you roll the stock over into an IRA, essentially the same thing occurs. The rolled-over stock no longer retains its basis. When you eventually sell it and pay the proceeds out of your IRA, the distribution is taxed as ordinary income. Your best choice may be to distribute your company stock rather than roll it over.
Here’s how it would work: Employer stock transferred from your 401(k) to a taxable account (not rolled over to an IRA) is taxed at ordinary income rates on the average basis of the shares, rather than the current market value when you make the distribution. You pay ordinary income tax only on its basis. If you then hold it with the expectation that it will increase in value, and it does, an eventual sale will be taxed as a capital gain.
The top rate for long-term capital gains is currently 20%. If you are retiring at an age before you become eligible for Social Security payments, this stock can become an income supplement to draw on at capital gains rates. If you’re planning any income-shifting strategies between years when you will have different tax rates, bear in mind this additional income and any further income you expect from stock grants.
Seriously consider this strategy if your company pays a significant dividend.
Qualified dividends are also taxed, under current law, at 15% or 20%, depending on your income. Numerous companies with broad-based stock plans also pay a dividend of 2% or more. Many of these companies have increased their dividend dependably over the years. This dividend can offer an attractive increasing stream of retirement income for you. But don’t forget: the dividend isn’t guaranteed; and stock prices go up and down.
Consider traditional and Roth IRAs alongside your 401(k).
If you have additional compensation income this year from your employee stock option exercise or restricted stock vesting and are not eligible to fund a Roth IRA or deductible IRA, you may want to consider funding a nondeductible traditional IRA. For the tax year 2024, the contribution limits for a Roth IRA are $7,000 for a person under 50, and $8,000 for a person who is 50 or older before the end of the year. To be eligible for maximum contributions in 2024, married joint filers must have Modified Adjustable Gross Income (MAGI) of $230,000 or less, and single filers must have MAGI of $146,000 or less. The phase-out range for partial contributions extends from there up to an income ceiling of $240,000 for married joint filers (up to $161,000 for single filers), beyond which contributions are not allowed.
The income limit on conversions from traditional IRAs to a Roth IRA was eliminated back in 2005. This law also eliminated the rules that prohibited married separate filers from converting traditional IRAs to Roth IRAs. If you are already contributing the maximum to your 401(k) at work, now may be a good time to consider making a nondeductible contribution to a traditional IRA with the expectation that it can be converted to a Roth. If you have not been making IRA contributions, because of the income restrictions, perhaps it’s time to take a look at nondeductible contributions as part of your retirement savings plan.
When you do convert your traditional IRA to a Roth IRA, you will owe ordinary income tax on the value of any tax-deductible IRA (speak with your tax advisor about the related calculation). Income from your stock grants can help pay this tax. Also remember to consider upcoming income from stock compensation (e.g. known restricted stock/RSU vesting) in your tax projections when you are deciding whether to convert.
There is much to consider when you're planning your retirement. Strategic plans should be in place for the entire time you are employed. If you are lucky to have employee equity compensation, your planning is a bit more complex because you also need a tactical plan for your company stock grants. This can be a good problem to have but it may also require you to get some qualified help. Make sure the financial planner who helps you knows as much about employee stock compensation as they do about retirement generally. Your plan must weave these two together in order to maximize your retirement confidence.
The views stated in this letter are not necessarily the opinion of Cetera Advisor Networks LLC. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed.
*For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks LLC nor any of its representatives may give legal or tax advice.
The return and principal value of stocks fluctuate with changes in market conditions. Shares when sold may be worth more or less than their original cost. A diversified portfolio does not assure a profit or protect against loss in a declining market. Asset allocation, which is driven by complex mathematical models, should not be confused with the much simpler concept of diversification. All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful.
All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful. Past performance is not an indication or guarantee of future results.