Don’t forget about maintaining diversification in your invested savings

You work at a great company that’s going places. In addition to a generous 401K you have additional opportunities to receive more company stock. Should you buy more?

• Usually, it’s best to maintain diversity in your portfolio and NOT purchase additional stock from the company you work for

Your paycheck represents a significant income stream. You may also have additional stock in the form of stock grants and stock options. By buying more stock you are overinvesting in your company.

If things go south, not only is the company stock value in jeopardy but your job, and the income stream it represents may also be in jeopardy.

Just ask the folks that used to work for Enron or Lehman-Brothers, or even GE.

If you work for a big company, odds are it may already be part of the S&P500. You’re already invested if you hold index funds.

As always, there are exceptions.

Buying company stock within your 401K

Most 401K plans include an option to invest a portion of your savings in the company stock. Traditionally, companies assumed you would work harder if you had some stake in the overall success of the company.

Avoid this option.

Do you get a company match? That match may come to you in the form of company stock.

Obviously, never say no to free money or free stock.

Once you receive stock within your 401K you always have the option to sell it and purchase a different investment, such as a stock index mutual fund.

Because the transactions occur within your 401K, there are no tax implications for buying and selling things within the account. But as always, check if there are commissions or fees.

Interestingly, many companies are starting to acknowledge the issue and have stopped offering their own stock within 401Ks.

Many experts say to have no more than 5% of your portfolio in company stock.

This is based on old studies indicating that holding at least 20 individual stocks (or 5% of each) results in good diversification. Some of these old assumptions are under fire, arguing that holding even 30 individual stocks may be too few. Holding mutual funds or exchange-traded funds (ETFs) with diverse holdings is preferred.

Also, none of these diversification guidelines consider the fact that your paycheck is also at risk.

Stick with the available mutual funds and ETFs.

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Net unrealized appreciation of company stock

In fairness, there is a unique tax advantage to holding company stock within a 401K or other Qualified Plan. But it’s unlikely to be useful under most circumstances.

Once you’re old enough to not get hit with a 10% penalty—at least age 55 if you’ve recently left your job—then you have the option of taking a lump-sum distribution.

All investments that are not your company stock get taxed as ordinary income, just like any other distribution from a Qualified Plan.

However, company stock is treated differently. Net unrealized appreciation (NUA) is the difference between the price at the lump-sum distribution and the price when you either received or purchased the stock within your 401K.

• For example, your company gives you 1000 shares at $10 per share in your 401K. Years later you leave the company and take a lump-sum distribution. The stock is now worth $15 per share. Your NUA is $5 per share or $5000 total ($15 – $10)
• Because you were given the 1000 shares, you owe ordinary income on their original value, or $10 per share, or $10,000 total

NUAs are treated like long-term capital gains which almost always have a better tax rate than ordinary income.

You can sell your stock right away, owing taxes on long-term capital gains, or sit on it. If you sit on it, you defer capital gains taxes until you ultimately sell the stock.

Like any stock, if held one year or less, it is subject to short-term capital gains which are taxed like ordinary income. Stock held more than one year gets the more favorable long-term gains treatment.

• After paying taxes on the original $10,000 value, you decide to sit on the stock and sell it 6 months after your lump-sum distribution. The stock is now worth $18.
• You owe taxes on long-term capital gains on the NUA of $5,000 and $3,000 in short-term capital gains (1000 x ($18 – $15))

Or

• After paying taxes on the original $10,000 value, you decide to sit on the stock and sell it 18 months after your lump-sum distribution. The stock is now worth $18.
• You owe taxes on long-term capital gains on the NUA of $5,000 and $3,000 in long-term capital gains

Lengthy explanations aside, the only way this would be of benefit would be if the account were filled 100% with company stock, as everything else gets the usual ordinary income tax treatment.

This may be the case if you have a separate stock bonus plan composed of 100% company stock.

But even so, why would you wish to take a lump-sum distribution rather than keeping it within a tax-deferred account—either a 401K or rollover IRA? You presumably are going to use that money for retirement.

Plus, stock bonus plans run by publicly traded companies are required to offer diversified alternatives to company stock.

However, if you don’t stay with your company long (and are old enough) and find yourself with either a stock bonus plan or a smallish 401K balance, this may be an option.

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Stock grants (RSAs and RSUs)

Never say no to free money. Poorly diversified accounts are better than no accounts.

Your company may also offer you stock grants, either Restricted Stock Awards (RSAs) or Restricted Stock Units (RSUs). They are “restricted” because usually, they need to vest first before you can claim them.

Vesting may be based on a specified time (eg, two years), and/or a specified company condition (eg, company acquisition).

Like anything else that has a vesting period, if you leave the company before something vests, you lose it. Likewise, there are no tax consequences until something vests. Why pay taxes on something you are at risk of losing?

RSUs represent “potential” ownership, while RSAs represent “actual” ownership, including voting rights.

Like RSUs, RSAs are still restricted until they vest: you may not sell them and invest in something else.

Once stock grants vest, you owe taxes on the fair market value (FMV) on the date they vest. Taxes are usually taken out automatically and will show up on your W2.

W2 income is ordinary income but is also subject to payroll taxes (FICA) on top of income taxes, representing an additional cost of 7.65%. Specifically a tax of 6.2% for social security plus 1.45% for Medicare.

The FMV is now your new basis for tax purposes. As you’ve already paid taxes, you can sell the stock right away, and improve your diversification, or sit on the shares for months or years.

• 1000 shares vest and are each worth $10 on that date. Your W2 will reflect an additional $10,000 in income.
• You sit on the shares for another two years and sell them for $25 per share. You now owe taxes on long-term capital gains of $15,000 (1000 x ($25-$10)).

Stock Options

You may also receive stock options. These options allow you to purchase company stock in the future at a discounted price.

They work great at companies that are young and growing. Not so great at established companies with a stable or dropping stock price.

When you are granted the options, you get a strike price (also called the exercise price), which is usually the current market value of your company stock.

There is a vesting schedule. If you leave the company before your options vest you lose them.

Once they vest, years later, hopefully, the company stock is worth more than the exercise price. You can exercise your options right away or wait and see if your company stock goes up more.

There is usually a limit on how long you can keep your options. They may expire after ten years. Make sure you exercise them before then! (Not all companies will remind you of this.)

If the stock price stays constant or goes down, your options could expire worthless.

When you exercise you buy the stock at your exercise price.

• You exercise your option to purchase 1000 shares at your exercise price of $15, paying $15,000
• The stock is currently worth $25. You may sit on your stock or sell right away and get you $10 gain.

Most of us don’t have the cash to purchase big lots of stock. Instead, we can do a “cashless” exercise by borrowing the cash, exercising our option, immediately selling, and paying back what was borrowed. All of that happens in the background, we just get our profit. ($10 per shares or $10,000 in the example above.)

Our entire gain is considered ordinary income and will show up on our W2.

The most challenging thing about options is to decide when to exercise. Do you exercise right after they vest and use the cash for a more diversified investment?

Or, if you have more years before they expire, do you hold off and see if the price goes up?

In most cases, it may be wisest to do partial exercises over several years. You reduce the overall risk and reduce your tax burden by spreading out the gains.

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NQSOs and ISOs

Stock options come in two flavors: non-qualified stock options (NQSOs) and incentive stock options (ISOs) which have different tax treatment.

Like most of us, you probably did a cashless exercise. There is little difference between ISOs and NQSOs in this situation. In both cases, your gain is taxed as ordinary income and is reported on your W2, but with the ISOs, there’s an added benefit in that no payroll taxes are applied.

If you have NQSOs and exercise them, your immediate gains are taxable as W2 income, subject to payroll taxes. If you hold on to the stock, and the stock price continues to go up, you’ll have additional short- or long-term capital gains when you sell.

ISOs get special tax treatment, but only if all the conditions are followed. If any rules are broken, they are taxed like NQSOs, but no payroll taxes are taken.

• Upon exercise, no taxable income is realized (owed). (However, AMT income is realized.)
• Stock must be held at least two years from the grant date AND one year from the exercise date
• Assuming the holding period above is met, when sold all gains are treated as long-term capital gains

For example

• Back when you exercised your stock options, the stock was worth $25, but you paid the exercise price of $15. (Only an AMT gain is realized at this point.) One year later you sell when the stock is worth $30. You pay taxes on long-term gains of $15,000 (1000 x ($30-$15)).
• If your options had been NQSOs, you would have paid taxes on ordinary income of $10,000 when you exercised (plus payroll taxes), then taxes on long-term gains of $5000 when you sold one year later. The gains are identical, but the tax treatment is not.

Employee Stock Purchase Plans (ESPPs)

Your employer may even allow you to purchase company stock directly through an ESPP plan. Usually, you get a discount on the purchase, up to a maximum of 15%.

You are limited to an annual purchase of no more than $25,000 company stock.

That represents an immediate return on investment! A five percent gain may not be worth it, but a 15% gain may be another story.

Like ISOs, there is preferable tax treatment if you keep your stock longer than a defined holding period (usually greater than one year).

But again, do you want to take the risk? If you have an immediate gain, it may be best to lock it in and reinvest elsewhere.

However, if you sell immediately, your gain is W2 income including payroll taxes, not just ordinary income.

If your ESPPs generated a gain due to a 5% discount, it’s now been partially wiped out by income taxes and FICA. Your 5% gain may be more like 3.5%.

Sure, you could follow the holding period rules but you’re taking a risk that any gains may be wiped out. That’s not a great return for that kind of risk.

Should you hold long enough to optimize taxes?

Most of the things mentioned above are taxed as ordinary income when you sell. There are a few things, such as vested stock grants, that will either be taxed as either short-term capital gains or long-term capital gains, depending on how long you hold onto them after you take possession.

If you sell at one year or less, then any gains are considered short-term and are taxed like ordinary income. Anything that you hold for greater than one year is taxed as a long-term capital gain and gets a better tax rate.

Depending on where you fall in the tax brackets you may be tempted to hold onto something for greater than one year to get a better tax rate.

Keep in mind you are taking a risk. Yes, if you work for a sedate company, your stock may be unlikely to drop in the interim.

However, if the stock hits a new high, but you decide to wait… You are risking a drop.

Netting a lower gain due to unfavorable taxes is still preferable to no gain at all!

Sell when the stock hits your “ideal” price. Tax concerns should be secondary.

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Avoid the appearance of insider trading

With all this company stock that you may be buying and selling its important to lay off when you know non-public information that may affect the stock price.

• For example, you work in the Regulatory group of a pharmaceutical company. Your new drug is just about to get FDA approval (or not). If you happen to be privy to communications with the FDA, then you are temporarily banned from buying or selling any of your company stock

If you are aware of insider information that you then use to purchase (or sell) stock anticipating that it may go up (or down) once this information becomes publicly available, you are guilty of insider trading.

You may recall that Martha Stewart famously spent time incarcerated because of insider trading.

Likewise, if you tip off friends and family and they purchase (or sell) stock, you are all guilty of insider trading.

But what if you are a corporate peon and know nothing?

Not only is it important to avoid insider trading it’s also important to avoid the appearance of insider trading.

If you have an impressive job title and suddenly start buying or selling large lots of company stock, red flags will be raised at the SEC.

It’s much better to have a routine of selling small lots of exercised stock options, stock grants, and 401K company stock. Avoid big and flashy.

The point is there are restrictions on when you can sell company stock, especially if you are in the know. This gives you far less control to get rid of something that may not be performing as well as anticipated.

• Unless there’s a generous discount, avoid buying company stock
• Sell and diversify stock options and stock grants on an ongoing basis

What if you work for a hot start-up?

This one’s a tough question. We’ve all heard the stories of folks retiring before age 30 as a result of their company stock going through the roof.

Keep in mind, we rarely hear the stories of those who worked for a company that went belly-up, with formerly valuable stock close to worthless.

Another consideration: many times, a struggling company will be acquired by a second company and the former’s stock will get a significant boost (and options automatically vest).

If you are sitting on stock grants or stock options sometimes its difficult to know when to sell. Keeping them is always a risk. But some risks pay off and pay off big.

A few questions to ask yourself:

• What is your risk tolerance?
• Do you need that money for something now or in the near term?
• How would you feel if that money disappeared tomorrow? Obviously, you’d be upset, but you can still work and make a living. Perhaps at a new start-up?

If you’ve earmarked that money for something important, then it may be best to sell and invest the money conservatively. Perhaps you have debt to pay off or a down payment on a new home. Or the college fund for the kids.

If having all that money would be nice, but you could continue without it, then taking the risk may be worth it.

I’ve used my company stock options to pay off credit card debt and put down a down payment on both my first and current home. Although I certainly can’t retire, it has helped my finances immensely.

Only you can decide.

Good luck.

Additional Reading

• Rollover Revisited: Why Sticking With a 401K May Be Better. Should you rollover your retirement savings to a new employer’s 401K or a rollover IRA?

• Beyond Index Funds: Why Buy Actively Managed (Sometimes). How to pick a fund that aligns with your values and investing style.

• Index Fund Investing for Beginners. Get started saving for your long-term financial goals

First photo credit: Negative Space on Pexels

This information has been provided for educational purposes only and should not be considered financial advice. Any opinions expressed are my own and may not be appropriate in all cases. All efforts have been made to provide accurate information; however, mistakes happen, and laws change; information may not be accurate at the time you read this. Links are included for reference but should not be considered an implied endorsement of these organizations or their products. Please seek out a licensed professional for current advice specific to your situation.