- A substantial stock awards windfall can trigger a variety of investment, estate planning, and charitable giving decisions in the near and longer term.
- There are unique tax planning considerations with incentive stock option exercises.
- Due to the complexity of stock plan rules and tax laws, consider working with a team of financial professionals to create stock grant exercising strategies within an overall financial plan.
Windfalls can take many forms—you win the lottery or become a 6-figure influencer on social media, you inherit money, you sell a business, or you hold a large stock position that skyrockets. But one of the most common windfall events is realizing big gains through equity stock awards.
Just imagine you suddenly became a multi-millionaire. How would your view of money change? How would this new wealth change your relationships? Would you plan differently? How would you find the right financial and tax advisors to help you achieve your new goal?
Getting it right isn't easy. According to the National Endowment for Financial Education, 70% of people who come into sudden wealth are broke within a few years.* Even when resources last for the lifetime of the recipient, it is rare for the sudden wealth to last multiple generations.
There are lots of reasons: pressure to provide financial assistance to others, a lack of financial acumen or planning, or simply failing to recognize unsustainable spending. Ultimately, having a financial plan, and coordinating with trusted advisors to help frame and oversee the implementation of your plan, can help you to identify and achieve long-term goals while understanding and managing risks.
Equity comp windfalls
When managing equity compensation, it's important to plan for the long term, keeping your family and estate plan considerations in mind. And because of the complexity of stock plan and tax rules, it makes sense to work with experts. "We suggest that people work with a team of financial professionals to look at the potential impact of exercising stock grants 10 years out, and how it fits into their overall financial plan," says Tayo Ogundiya, an executive planning consultant at Fidelity who has worked with several Silicon Valley firms as they became public companies.
Let's examine some of the challenges individuals may face as they receive equity compensation windfalls.
Two key windfall wealth events: stock option grants and restricted stock
The main forms of equity compensation that create a sudden "windfall" wealth event are stock options and restricted stock. "Each of these forms of equity compensation come with specific planning considerations, benefits, and potential pitfalls," explains Fidelity equity compensation analyst Christopher Cote. "It's important to consider your risk tolerance and exposure to your company stock, while being aware of some of the broader tax and planning consequences that impact your tax situation, not just this year, but for many years to come."
If you work for a publicly traded company (or one planning to go public), consider how your company will be received by the market:
- Where will the stock price go?
- How much will your equity compensation be worth in 6 months, 1 year, 5 years?
- What does this money mean to you and what does it need to do?
- How comfortable are you with 30%, 60%, or even 90% of your wealth connected to the success or failure of one company?
To answer some of those questions, let's look at different award types and how they function.
Gaining access to the value that vested awards create
Both restricted stock and stock options are granted to the recipient, but the recipient does not immediately have access to the value of these awards until they vest. Vesting schedules can vary, but they typically take place over 3 to 4 years on a schedule determined by the company. You as the recipient may also continue to receive additional awards each year. When restricted stock vests, it converts into shares of company stock. Stock options are particularly sensitive to price changes, are more volatile than other forms of equity compensation, and require you to decide on the right time to exercise.
Some stock awards are subject to a lock-up period that restricts the sale of stock for a certain period of time after their company goes public. This period is an ideal opportunity for planning and creating a strategy for when their lock-up period expires. Companies often see a great deal of volatility after trading starts and clients subject to lock-up periods may see the company stock price reach levels they did not think possible, or fall to levels far below the opening price.
FOMO and the volatility of stocks
For individuals who have received any kind of equity compensation awards, understanding your company's plan rules and knowing when you can exercise options and sell underlying shares can be helpful to seize an opportunity to sell certain lots of company stock. "I've worked with employees from cloud computing and tech clients who watch their company's stock price on an hourly basis. Dramatic swings in value can foment the fear of missing out (FOMO) on future growth of the company by selling their stock, or it can create a sense of urgency to sell shares to capitalize on high prices," says Ogundiya.
Once you have considered how comfortable you are with exposure to your company stock, how concerned you are about market volatility, and what you want this money to do, it is important to plan for the future and think about strategies to protect this potential wealth. An important aspect of planning is understanding your risk tolerances and avoiding or mitigating any unnecessary risk.
Tip: Remember, the concentration of a single asset can put your wealth at risk. That's particularly true for company stock, where your salary, deferred compensation, benefits, and investments may be tied to the same company. Read Viewpoints on Fidelity.com: Company stock plans: Managing risk
Incentive stock options and AMTs
Typically, no taxes are withheld when exercising incentive stock options. The actions the individual takes after the exercise will determine the tax outcome. This could range from ordinary income if they sell the shares immediately or within the disqualifying disposition period, possible AMT (alternative minimal tax) in the year of exercise, and capital gains considerations (subject to change) if they hold the shares until a sale which would be classified as a qualifying disposition.
"If you choose to spread out the income tax impact by exercising a few stock options at a time over several years, you're slowing your diversification strategy," says Ogundiya. "Keep in mind, as your personal financial wealth has become more complex, you may have outgrown your prior CPA (certified public accountant) or your ability to file your own taxes. Consider working with a tax professional who specializes in equity compensation and can provide strategies to help manage your AMT exposure."
Tip: Learn more about AMTs to help determine if you may be subject to the AMT.
Long-term goals for your family and legacy
Many wealthy clients want to broadly provide for their family, while minimizing the impact of taxes. Some have specific ideas like providing for children or grandchildren's education expenses, and some want to prioritize a charitable legacy.
Creating a plan should start with identifying your specific goals and concerns, before considering how best to achieve your goals and minimize risks. If you receive a substantial windfall, take a step back, and consider:
- What do I hope to accomplish short term?
- What financial or family situations do I hope to encourage or enable in the long term?
- What is my desired retirement lifestyle?
- What level of ongoing financial support do I expect to provide for my family?
If you receive a substantial windfall, you might be concerned about the money being squandered by your beneficiaries. To mitigate these concerns, consider working with an attorney to create a trust designed to protect beneficiaries from risks associated from irresponsibility within the family, or from beneficiaries losing inherited wealth in a divorce, or generally to financial predators and creditors.
If you are comfortable with your own financial footing from a substantial windfall, you may want to consider transferring some assets to your family or loved ones. Currently, the federal lifetime gift and estate tax exemption amount is historically high ($11.7 million per person in 2021, subject to future changes). Also, while some states have a separate state estate tax, few states have a gift tax.
"For many high net worth families, this environment can be favorable to implement various gifting strategies," explains Jordan Klein, vice president of Advanced Planning at Fidelity. "Knowledgeable estate planning attorneys can assist with various gifting strategies, potentially providing a legacy for multiple generations, and making use of the current estate tax exclusion amount."
Tip: Read Viewpoints on Fidelity.com: Do you need an estate plan?
There are a few options designed to potentially reduce the tax bite of your stock awards windfall. If your company stock is held within your 401(k) or workplace saving plan, a tax strategy known as net unrealized appreciation (NUA), when applied to company stock, can help you effectively pay lower capital gains rates on a portion of your tax-deferred assets instead of paying the typically higher ordinary income rates. Always consult your tax advisor to understand what makes sense for your situation.
Tip: Read Viewpoints on Fidelity.com: Make the most of company stock in your 401(k)
Thinking about the potential tax impact on your family's next generation? Some clients who plan early and anticipate a windfall may utilize sophisticated structures like grantor retained annuity trusts (GRATs), designed to shift future appreciation of assets for their heirs. Notably, some assets with a potential for substantial appreciation may have associated restrictions on transferability, so gifting may not always be feasible in this way.
If you are charitably inclined, consider donating long-term appreciated securities, because it can help reduce capital gains taxes and provide a tax deduction that could offset income for shares vesting in that year. To make your giving as efficient as possible, you may make larger donations in years when you are in a higher tax bracket to receive a greater deduction. Another tax-efficient option: a donor advised fund such as the Giving Account® through Fidelity Charitable®. It allows you to contribute a variety of assets, invest the balance for potential tax-free growth, and support charities over time—for maximum impact.
Tip: Read Viewpoints on Fidelity.com: Is a trust right for you?
Windfalls can impact you in a wide variety of ways, both financially and psychologically. Some people who receive windfalls pay off school loans and mortgages. Others pay for major home renovations or purchase a new home. Still others give away lots of money to friends, family, and charities. Everyone's different.
If you've received a substantial windfall, the investment, estate planning, and charitable giving decisions you make in the near term, and in the long term, can have a substantial impact on you, and your family, well into the future.