We’ve all heard the adage ‘Pay Yourself First.’ This is a foundational concept for saving money and creating wealth that we typically assume to be pretty simple. And for many, it is, because of the straightforward nature of W2 salaries paid in weekly or bi-weekly installments. You pick a predictable percentage of that predictable paycheck and you save it before you even see it, allowing you to also predict how much you can save over time and how much you can spend on your lifestyle.
For corporate executives, there is typically much more to consider than saving a portion of a bi-weekly salary. In fact, for a lot of corporate executives, 10-40% of their base salary is paid as a once-annual or semi-annual performance bonus, then another 10-40% is awarded in stock grants that may not be available to exercise until a later date.
So, if you’re a corporate executive, you could be looking at nearly half of your total annual compensation as ‘up in the air’ based on forces like company performance, future stock performance, and vesting schedules. With all of this potential variability, how do you decide what to spend and what to save?
Step 1: Understand What You Have
You may be going through performance reviews and you may be discussing base salary adjustments, bonus opportunity, and stock grants for the year. The first step to take is to figure out what is included in your total compensation package and understand how those incentives are awarded.
Most monetary bonuses are based on personal performance and company or business unit performance and are awarded once or twice annually. The more complex form of compensation is stock grants.
Stock grants are awarded to employees by companies in one of two ways: as actual stock OR as stock options (the rights to buy company stock at a guaranteed price in the future.)
Actual stock can be awarded in three ways:
- Restricted Stock Units (commonly called RSU’s) come with a defined vesting schedule, meaning you are awarded units at one point, and they ‘vest’ or become accessible to you to exercise (sell) at another point in the future.
- Performance Stock Units (PSU’s) are typically tied partially to individual performance and partially to company performance. The amount of stock you receive varies based on how well you or the company performs.
- Deferred Stock Units (DSU’s) are more rare and, similar to RSU’s, encourage employee retention because the stock is not accessible until a set vesting date. Deferred stock differs from Restricted stock specifically because restricted stock vests gradually, and becomes entirely accessible on the vesting date, while DSU’s are not accessible until after the vesting date.
Actual stock may be on a vesting schedule, but it does not require the employee to spend money to acquire it. Stock options are the rights to purchase company stock at a set price in the future, with the employees own money. It’s not required to purchase the stock, but there isn’t really a benefit to the employee if the options are not exercised. Conversely, if the stock price increases drastically over time, stock options are a huge potential advantage to those who hold them.
Stock options can either be Incentive Stock Options (ISOs) or Nonqualified Stock Options (NQs). The key difference here is when they are taxed and when they can be sold to be taxed at a lower rate. There is great variability in the potential value of stock grants and stock options, which is why step 2 is important.
Step 2: Understand When You Get It (and When It’s Taxed)
It’s important to know when and how your stock options vest: for example, do you gain access to them annually, 10 years after they are awarded, OR do you gain total access to all awarded stock grants after 10 years of service?
It’s also important to know that the right to purchase stock options is typically for a defined period of time. In our experience with corporate compensation, that period of time is often 10 years. So, once those options are available, they are not available forever. They should be evaluated periodically based on the market stock price and other compensation for that year, in order to have a clear picture of taxable income and capital gains.
Most Incentive Stock Options (ISO’s) have preferential tax treatment at the time the stock is exercised, i.e. purchased by the employee at that guaranteed price. The benefit being, the employee only has to pay the price of the stock, and not capital gain taxes at the time of purchase. For example, if you got an ISO grant of 1,000 shares at $10 per share, that means you have the opportunity to buy company shares for $10 per share up to 1,000 shares, even if the market price is higher, say $15 per share.
As long as you meet certain holding requirements (it’s worth knowing what those are, too!) you don’t have to pay taxes on the immediate $5 gain with ISOs, you’d only owe taxes when you sell those shares. If you sell shares without meeting the holding requirement, it could be taxed as ordinary income or short term capital gains, which are typically at higher rates.
Non Qualified Stock Options (NQ’s) differ in that you have to pay the price per share and taxes on the immediate gain. For example, you exercise stock options for 1,000 shares at $10/per share and the current market value of the stock is $15 per share, you will have to pay taxes on the ‘gains’ of the additional $5 per share ($5,000) that you now own.
You can see how complex and unpredictable corporate compensation can become, and how one could wind up with quite the tax burden if they aren’t careful. Knowing what you get and when you get it are important, but to make decisions on what to do with your bonus or stock grants, you have to practice step 3.
Step 3: Understand How it Fits into Your Family’s Financial Picture
Both bonuses and stock grants can create a wide range for your annual income, which may change how you save, spend, or sell in a given year. It’s important to have an understanding of your family’s budget, needs, and long term goals to give context to how you make these decisions. Your accountant and your financial advisor are important allies in creating a structure that allows you to work toward your future financial goals and enjoy the fruits of your labor.
For example, an important tax consideration is that most companies have a default tax withholding percentage, one that is almost always well below an executive’s actual tax rate. This means if you are not diligent in working with your advisor and accountant to understand what you will actually owe, you may be left with a big tax bill at the end of the year. No one wants to think they are saving for a lake house with their bonus, only to find out they have to use it to pay taxes.
As a corporate executive, you can be strategic in how you manage your bonuses and stock options–serving your family’s financial plan over time instead of accepting a year as feast or famine. With the right structure in place, you can pay yourself first and enjoy the freedom it brings.