As a leader of your company, you have sacrificed and made the hard decisions. You’ve mentored, coached, and developed your team. As your firm has enjoyed success, you’ve created financial benefits for its owners—shareholders, if you’re incorporated—and the people who work for you. Also, in all likelihood, you are reaping personal benefits of that success in the form of executive compensation.
Of course, along with the benefits comes the responsibility of making smart choices as you incorporate your executive compensation into your overall wealth-building plan. In other words, the nuances of executive compensation require careful attention to some specific elements and potential issues. Let’s talk about some of the basics of executive compensation, how they might fit into your long-term financial strategy, and some particular matters that deserve specific focus.
Base Salary and Cash Bonuses
While these elements are unlikely to provide the bulk of your wealth-building opportunities, you should still exercise care with them, as they are the most predictable elements; forming good habits here can pay dividends for your financial blueprint. Because they are not dependent on valuation of company equity, vesting schedules, or other variables that typically impact other parts of your total compensation package, they don’t necessarily require specialized planning. But here are some tips on how to make sure they are working as hard as possible for you:
- Build and maintain cash reserves to ensure portfolio liquidity;
- Consider funding a tax-advantaged 529 plan for future educational expenses;
- Defer a portion in your deferred compensation plan, if available;
- Pay nondeductible debt down to an absolute minimum;
- Keep your mortgage debt as low as practical, both on your primary home and any other residential property;
- Own life and disability insurance separately from the company;
- Fund charitable causes with a gifting plan.
Equity-Based Compensation
Here is where you are likely to have the opportunity to build major wealth. Equity-based executive compensation typically comes in the form of company stock or options to purchase said stock. The incentive is obvious: the more your efforts contribute to the financial success of the company, the greater the value of your holdings. Certainly, there is risk involved, but understanding how equity-based compensation works can help you make a plan for mitigating that risk as a part of your long-term plan.
Stock Options
A stock option, as the name implies, gives you the right to purchase a certain amount of stock at a predetermined price (the “strike price”) for a specified period of time (the “option period”), typically about 10 years. Most stock option plans operate on a vesting schedule, which is the amount of time you must be with the company in order to be able to exercise the option. Once you are vested, you may determine the time when you will exercise the option to purchase the stock. There are two main types of stock options.
- Qualified incentive stock options (ISOs): typically only available to C-suite executives, qualified ISOs incur no tax when they are granted, vested, or exercised (though you should consult with your tax expert about possible alternative minimum tax—AMT—implications). When the options are exercised and the stock is sold (assuming the appropriate holding period), gains are taxed at the long-term capital gains rate, which is typically less than the ordinary income rate.
- Non-qualified stock options: these receive a less favorable tax treatment than qualified ISOs; upon exercise, ordinary income tax rates apply and payroll taxes are due.
Exercising your options to acquire stock can be a very effective way to accumulate wealth. One risk, however, is that over time, much of your wealth is in a concentrated holding—i.e., your company’s stock. Because one of the most important tools for mitigating volatility in a portfolio is broad diversification, you should consult with your wealth advisor to discuss ways to reduce your exposure to a single stock over time. You may want to design a plan based on your anticipated retirement date. Or you may develop another strategy to unwind the position over a period of time. You will need to take care, however, to observe any requirements of your plan with regard to minimum shares required for retention (and also, as a practical matter, to demonstrate appropriate confidence in the company’s prospects).
Restricted Stock Awards and Restricted Stock Units
A restricted stock award (RSA) grants the holder ownership of stock subject to a vesting schedule; this may be either completion of a required period of employment or meeting certain incentive-based goals. Restricted stock units (RSUs) differ slightly in that, rather than granting direct ownership of stock on the grant date, they provide a commitment to receive a transfer of stock once the specified vesting conditions are met.
A key decision that comes with RSAs is whether or not an IRS Section 83(b) election should be made. This election permits the holder of the RSA to pay taxes on the stock at its present value rather than the value at the time of actual receipt. If the recipient believes the value of the stock is likely to be higher at the time the RSA is received, it could be advantageous to pay the taxes now, at a lower rate.
As you can see, there are a few complexities involved with executive compensation that require evaluation and planning. This is where a fiduciary financial planner can be of tremendous assistance. By analyzing your specific executive compensation plan in light of your particular situation, goals, and financial priorities, a qualified financial planner or wealth manager can help you develop a “custom-fitted” strategy that provides the tax advantages, portfolio characteristics, and timing that best meet your needs.
To learn more about The Planning Center and its fiduciary wealth management services, visit our website.
