For many corporate employees, the accumulation and growth of their employer’s stock over time becomes the source of significant wealth, but with that accumulation and growth the risk that comes along with investment concentration in a single company grows as well.
In fact, it is not uncommon at all to review a long-time corporate employee’s balance sheet and find that half of that person’s net worth is invested in company stock that has been awarded or purchased over time.
The stock accumulation makes sense given that equity compensation structures at many companies include stock bonuses, options, and employee stock purchase plans that all contribute to the accumulation of company stock over time. Some employees aren’t even aware how much stock has accumulated. And more often than not, the risk that comes with holding great quantities of one company’s stock are not in line with a client’s objectives and tolerance for risk.
The undesirable risk is why we so often find ourselves advising that a client diversify company stock absent constraints like holding requirements or charitable objectives to donate stock. We and numerous others have written about why you should diversify company stock before, but what I want to focus on here in the next couple posts is the how. Because diversifying the stock and limiting that risk isn’t always easy or, more specifically, cheap. If there is a cost involved, we want to make sure the benefit is worth it.
Take the example of a 20-year employee of a company that has grown significantly over that period of employment. Imagine that the employee has a $1 Million investment portfolio half of which is invested in company stock. The company’s growth over that time is a big reason why this employee now has a million-dollars invested, but as much as that employee has benefited from that growth, she is ready to finalize a retirement date.
She doesn’t want something specific to that company (e.g., a bad earnings report or a CEO scandal) to mean she has to work 5 more years! The employee knows that she wants to diversify away the risks that are specific to her company. The problem is that she has held the stock for so long that much of it has a very low cost-basis and she will need to pay capital gains taxes on $250 thousand dollars of the $500 thousand in proceeds when she sells the stock.
So, what are the options?
Option 1 – Sell it all now and pay the tax
In my next post, I am going to look at potential options for spreading out and reducing taxes, but it’s important to not rule out the most straight-forward (and most costly) option: sell now and pay the taxes.
No one likes to pay taxes. Taxes are a cost and costs, of course, matter. But costs should always be considered in light of the benefits. For many, this is especially difficult to keep in mind when it comes to paying taxes. At Cordant, we often advise to not “let the tax tale wag the dog”—i.e., don’t allow a tax bill to have undue influence when making a decision.
In the example above, a huge tax bill could very well be worth the benefit of diversifying the risk, if minimizing that risk would allow the client to finalize a decision like retirement or to buy a second home. Of course there may be ways to reduce taxes if we sell chunks over time or wait until after retirement when the client is in a lower tax-bracket (both options we will discuss), but if selling now is the best option for getting the client to the place they want to be, then selling now is the best option.
Next time, we will look at additional options for diversifying or minimizing the risk associated with concentrated single stock holding.
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