The opportunity to acquire company stock — inside or outside a workplace retirement plan — can be a lucrative employee benefit. But having too much of your retirement plan assets or net worth concentrated in your employer's stock could become a problem if the company or sector hits hard times and the stock price plummets.
Buying shares of any individual stock carries risks specific to that company or industry. A shift in market forces, regulation, technology, competition — even mismanagement, scandals, and other unexpected events — could damage the value of the business. Worst case, the stock price may never recover. Adding to this risk, employees who own shares of company stock depend on the same company for their income and benefits.
Time for a concentration checkup?
The possibility of heavy losses from having a large portion of portfolio holdings in one investment, asset class, or market segment is known as concentration risk. With company stock, this risk can build up gradually.
An employee's compensation could include stock options or bonuses paid in company stock. Shares may be offered at a small discount through an employee stock purchase plan, where they are typically purchased through payroll deductions and held in a taxable account. Company stock might also be one of the investment options in the employer's tax-deferred 401(k) plan, and some employers may match contributions with company stock instead of cash.
Be cautious of fallacies
Investors who build large positions in company stock may not be paying attention to the concentration level in their portfolios, or they could simply be ignoring the risk, possibly because they are overly optimistic about their employer's future. Retirement plan participants might choose familiar company stock over more diversified funds because they believe they know more about their employer than about the other investment options.
Other behavioral mistakes that individuals make is to look at past performance. It is easier to get caught up in recent upward growth of company stock and think things will continue. The saying “past performance is not a guarantee of future performance” should especially be applied to individual stock concentrations.
While tax consequences should always be considered as noted below, do not let the tax tail wag the dog – how the stock concentration ties to your overall asset allocation is a critical factor in deciding when to sell.
What can you do to help manage concentration risk?
Look closely at your holdings. What percentage of your total assets does company stock represent? There are no set guidelines, but holding more than 10% of your assets in company stock could upend your retirement plan and your overall financial picture if the stock suddenly declines in value. Moreover, the asset class represented by the company stock should be considered when determining the asset allocation for the balance of your portfolio.
Formulate a plan for diversifying your assets. This may involve liquidating company shares systematically or possibly right after they become vested. However, it's important to consider the rules, restrictions, and timeframes for liquidating company stock, as well as any possible tax consequences.
For example, special net unrealized appreciation (NUA) rules may apply if you sell appreciated company stock in a taxable account, but not if you sell stock inside your 401(k) account and reinvest in other plan options, or if you roll the stock over to an IRA. You could miss out on potential tax savings, because future distributions would generally be taxed at higher ordinary income tax rates.
As you diversify your holdings, you may also want to consider incorporating your charitable gifting. If you held the stock outside of a retirement plan and had significant unrealized gains in such stock, it may be beneficial to gift the stock to charity. Depending on other tax considerations, you may be able to receive an income tax deduction and avoid having to pay capital gains taxes on the holdings. If you were otherwise gifting cash to charity, this could save a significant amount in income taxes. If the stock is significant enough, you could even consider advanced charitable gifting techniques such as a charitable remainder trust.
When selling the shares, you should also consider the timing of recognizing any gain. Depending on your level of taxable income, capital gains taxes can be 0%, 15%, or 20%. In some cases, the additional 3.8% net investment income tax may apply. It may make sense to accelerate deductions in the year of sell or change the timing of recognition of other income – including harvesting capital losses -- to reduce the applicable capital gains tax rate.
If you did need to hold the stock for various reasons, you may want to consider various hedging techniques such as equity collars (buying a put option and selling a call option) or prepaid variable forwards. While these hedging techniques may not eliminate the concentration risk, these strategies could help minimize the risk.
Note that holders of various stock options should do additional analysis due to the different tax treatment associated with non-qualified stock options and incentive stock options. Coverage of stock options will be explored in another article.
Thus, the strategies selected for dealing with your concentrated stock should consider your overall asset allocation, goals, risk tolerance, time horizon, and income taxes. Dealing with concentration risk should continually be reviewed in such an integrated fashion.
Modified by Oasis Wealth Planning Advisors with initial preparation by Broadridge Investor Communication Solutions, Inc. Copyright 2017.