Education Center » Retirement planning and your equity awards

Retirement planning and your equity awards

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When you’re at the peak of your career, raising a family, paying for a child’s college education, or caring for an aging parent, it can be difficult to think about planning for your own future. When faced with these competing priorities, it may seem like there’s nothing left to contribute towards retirement. No matter how old you are now, or how many responsibilities you're juggling, you need to start preparing for your future as early as you can. The decisions you make during your pre-retirement years directly affect when you can retire and what level of income you can enjoy in those years.

How stock options can fit into your retirement goals

How much will you need to retire comfortably? We’re living longer and your retirement income may need to last 20 to 30 years or more. There is no such thing as one magic number that you should strive for, but Merrill Lynch suggests that you may need approximately 90% of your pre-retirement, after-tax income to maintain your current standard of living in retirement. The amount you may need changes often with variables such as your family’s employment status, your health, your standard of living, your children’s needs and wants, the financial markets, and more. Therefore, you should re-evaluate your progress toward building your retirement nest egg at least annually.

If stock options1 are a significant part of your portfolio, the analysis can be tricky. You shouldn't view options in the same way you view other equity, such as stocks or mutual funds. While options are an equity component, they may be riskier than stocks you may own outright or unvested restricted stock. The value of stock options can be highly volatile since they are typically subject to dilution by grants to other employees, have a set exercise price (typically at fair market value) even though the value of the underlying stock may decrease below that price, and the percentage of your investment portfolio they make up can change daily. In addition, they're concentrated in one company’s stock (your employer) and you don’t directly control the size of option grants and other equity awards you may receive each year.

Additionally, you may have large amounts of company stock in your 401(k) account. Therefore, it’s important to accurately assess how the value of your stock holdings—those held in options and otherwise—factor into your overall investment portfolio. A financial planning professional can help with this analysis.

What happens to your outstanding equity grants when you retire?

Exercising ISOs upon separation from your company

Alert! Even if your employer’s equity incentive plan allows vesting to continue or accelerates vesting at the time of separation from your company, you must exercise incentive stock options (ISOs) within three months of ending your employment to prevent them from becoming nonqualified stock options (NQSOs). Exercising ISOs and holding the shares directly can result in more favorable tax treatment than that of NQSOs, but ISOs can also trigger the alternative minimum tax, so you should consult your tax professional to discuss your situation.

Equity grants (such as stock options and restricted stock) almost always have vesting provisions that specify the times or circumstances when you will gain a nonforfeitable right to all or a portion of the grant. Your employer’s equity incentive plan or your award agreement will detail the vesting provisions that apply to your grant. Although vesting usually requires your continued employment at your company, many companies treat retirement more generously than termination of employment to work for another company. Closely review your employer’s equity incentive plan provisions for the rules and definitions that apply to “normal” retirement and “early” retirement to see if the plan treats vesting differently for each event. Then consider choosing a retirement date that maximizes the vesting of your equity grants, resulting in the highest percentage of vested equity awards (exercisable stock options or unrestricted stock) possible for your circumstances.

Stock options

The tax planning process is particularly important when you expect your stock options to account for a large part of your retirement nest egg. Many people begin exercising options well before retirement. This strategy can also provide diversification if your portfolio is heavily weighted in company stock.

Your tax professional can help you understand the implications of your exercise strategies and provide guidance on whether you should hold or sell your company stock, particularly with respect to the exercise of ISOs.

Restricted stock and RSUs versus stock options

Your investment portfolio might contain both restricted stock and stock options. Because stock options can lose all their value if the trading price dips below the exercise price, there is a perception that restricted stock and restricted stock units (RSUs) have more value than stock options. The security offered by restricted stock and RSUs may seem more beneficial as you near retirement because they may maintain some worth, even if the stock value declines. In addition, if your company pays dividends and depending on the terms of the equity incentive plan, you may receive dividends along the way or at vesting if you hold restricted stock (or a dividend equivalent if you hold RSUs).

However, stock options may have greater upside potential and thus can potentially produce more value than restricted stock and RSUs can. In addition, stock options, to the extent they are not subject to Section 409A of the Internal Revenue Code, as amended, generally give you more control over when you recognize the associated taxable income and generally provide longer “tax deferral” than restricted stock and RSUs, which usually become subject to tax at vesting (typically vesting within four or five years from the grant date). Some RSUs, however, give you the ability to defer share delivery and the associated federal tax (except for certain employment tax) until a future date, such as retirement, if you elect deferral soon after grant. Note that stock options generally expire 10 years from the grant date.

401(k) and IRAs

Income recognized from equity awards may be included in your total income for the purposes of calculating the amount you can contribute to your company’s 401(k) plan, but you should confirm this with your own company regarding the terms of the 401(k) plan. Currently, annual employee contributions to a 401(k) plan are limited to $18,000. Those who are at least 50 at any time during the current calendar year can contribute an additional $6,000, for a maximum possible employee contribution $24,000. These amounts are adjusted for inflation and may be increased in future years.

Therefore, equity compensation may allow you to contribute more to your 401(k) plan when (1) your contribution amount is capped at a specified percentage of your compensation and (2) your annual contribution is normally below the yearly maximum. You should confirm how much your maximum individual contribution amount is for a plan year with your company human resources professional or your 401(k) plan administrator.

In addition to contributions to an employer-sponsored retirement plan such as a 401(k) plan, for the current year you can contribute up to $5,500 to an IRA ($6,500 if you will be at least age 50 at any time during the year). Contributions to Roth IRAs are made with after-tax dollars, but qualified distributions in retirement will be free of federal, and possibly state, income tax. Contributions to traditional IRAs may be tax deductible, and earnings on contributions are tax deferred.

IRA contribution limits

For the latest IRA contribution and MAGI limits, visit IRS.gov.

Alert! You can open an IRA and make a contribution for a tax year up until the IRS tax filing deadline for that tax year.

Roth IRAs

Your eligibility to contribute to a Roth IRA is based on your modified adjusted gross income (MAGI) for the year. This is your regular adjusted gross income (AGI) with a few differences (e.g., any income from the conversion of a Roth IRA is not included in MAGI). If your MAGI exceeds the relevant income limits, you lose the ability to make a contribution of at least part (and possibly all) of the amount you could otherwise contribute to a Roth IRA. However, you can still contribute to a traditional IRA, and you can convert amounts in a traditional IRA to a Roth IRA regardless of MAGI, though you may owe income taxes in the year of the conversion. You could use the proceeds of any stock compensation that vests or is exercised to pay the taxes resulting from the conversion.

Traditional IRAs

When neither spouse is covered by a retirement plan at work, both spouses may make fully-deductible IRA contributions (although there still are annual contribution limits). However, when one or both spouses are covered by a plan at work, the deduction rules become more complicated. See IRS Publication 590-A for more information.

Making thoughtful choices

You have the opportunity to pursue whatever you want in retirement. But getting there depends on the choices you make today. When managed properly, equity compensation can make a significant contribution to your wealth accumulation goals, and your equity awards could be an important factor in helping to ensure that you don’t outlive your savings.

Learn more and take action

Visit the Equity Awards Education page for videos, quick tip guides and more to help you manage your awards.

Neither Merrill Lynch nor any of its affiliates or financial advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.

 
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1 This article is generally referring to stock options issued at fair market value that are exempt from Internal Revenue Code Section 409A and can be exercised at any time after vesting. Not all stock options have this flexibility. Contact your company and your tax advisor to assist you in determining when you can exercise your stock options.

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