The Big Risk in Stock-Based Compensation, and How Advisors Can Help

Under the NUA approach, your client would roll the shares of their former employer's stock into a taxable account. They would pay taxes on the cost basis of the shares. However, when the shares are sold in the future, your client would only be responsible for taxes on the difference between the cost basis and the amount the shares are sold for. The tax on this difference would be at the preferential long-term capital gains rate if held in the taxable account for at least a year. If the shares were simply rolled over to the IRA account, they would ultimately be taxed at their full value including any gains since your client acquired them. 

The NUA approach can result in significant tax savings for your client in cases where the stock has enjoyed significant appreciation over their aggregate cost basis in the stock. Another advantage of the NUA approach is that these shares will not be subject to required minimum distributions. 

Note that assets other than these shares held in the 401(k) would generally be rolled into an IRA in order to preserve their tax-deferred status. 

Concentrated Stock Positions

At the end of the day, stock compensation becomes part of your client's investment portfolio, unless the compensation is in the form of options that expire without being exercised. 

Concentrated positions can be the result of stock-based compensation or simply from a client holding an investment that has appreciated significantly in value over time. For example, long-time holders of stocks like Apple or Microsoft may find themselves with large, low-basis positions in the shares, even after the tech sector turmoil of 2022. 

Regardless of the reason, a large, concentrated stock position can pose a risk to your client. Having a high percentage of your client's portfolio concentrated in a single stock poses a risk in the event that the stock suffers a correction. For example, Amazon stock was a stellar performer through late 2021 but has since dropped over 50% from those highs.

Additionally, stocks like Apple, Microsoft and Amazon are perennially among the largest holdings in index funds that track the S&P 500 index, domestic large-cap growth benchmarks or funds that track the total U.S. stock market. This will extend the impact of a decline in one of these stocks to the extent that your client invests in one of these funds in addition to holding shares of these stocks directly.  

In the case of employer company stock, the risk is even greater. Not only is a significant portion of your client's investment portfolio affected by the performance of the shares, but their livelihood is tied to the performance and financial health of the company. If the company runs into financial problems your client could potentially lose their job, while at the same time a decline in the stock's value could decrease the value of their investment portfolio. 

When dealing with a concentrated stock position in a client's portfolio, it's important to review the situation with your client. Opinions vary, but some experts feel that a concentrated position is one that is 10% or more of an investor's portfolio value. 

If the source of most of the stock is a company stock compensation plan, you will want to be cognizant of any rules or restrictions inherent in the plan when looking to lighten up on some of the stock position. Tax implications must also be considered. 

Here are some options to consider: 

• Donate appreciated shares to charity or use them to fund a donor-advised fund. Your client can take a charitable deduction if they are able to itemize. Additionally, they will avoid the capital gains taxes that would have resulted from a sale of the shares.
• If appropriate for your client, they could donate some of the concentrated shares to a charitable trust such as a charitable remainder trust. They would realize tax benefits in some cases, have the satisfaction of having made a charitable donation and will benefit from the trust for themselves or other non-charitable beneficiaries.
• Use tax losses elsewhere in their portfolio, if applicable, to offset gains on the sale of any of the concentrated position shares held in a taxable investment account.
• If some of the shares in the concentrated position have come down in value to the point where they are worth less than their cost basis, sell some of them and realize a tax loss. Your client can then reallocate this money elsewhere as part of their portfolio rebalancing efforts.
• If some of the concentrated position shares are held in a tax-advantaged retirement account, they can be sold with no tax consequences, and the money can be invested elsewhere in an effort to balance out their portfolio. 

Summary 

Stock-based compensation can be a benefit for your client. It can add to their income and can offer them the opportunity to participate in the upside potential of their employer's stock. However, it's important to help your client understand all of the rules surrounding the type of stock compensation they will be receiving, as well as any tax implications. 

It's also key for your client to remember that at the end of the day this company stock is part of their investment portfolio and that it needs to be managed accordingly. If their portfolio becomes concentrated in one position, whether from their stock compensation or other reasons, it's important to have a strategy to reduce their portfolio's dependence on that concentrated position in an orderly fashion.