For many American workers, there are no words more magical than “company stock.” But while owning a piece of your company can have obvious financial rewards, it can also have a downside risk that’s potentially greater than investing in somebody else’s company.
“In general, these plans are a very good thing for employees, but each case is a little bit different, and it always pays to do your research,” says David White, founder of David B. White Financial in Bloomfield Hills, Mich.
Here are some considerations to research so you can tell the difference between a great wealth-building opportunity and a workplace dud.
There are two ways employees can earn company stock, according to the U.S. Securities and Exchange Commission. Employees are sometimes granted stock options as part of their annual compensation. In the typical case, those options entitle the employee to buy a predetermined number of shares at a specified price on a specified date. While the employee may be restricted from selling for a period of time, options can dramatically increase the employee’s total compensation, assuming the stock rises in value relative to the option price.
Another common method for compensating employees with stock is an employee stock ownership plan, or ESOP. ESOPs allow the company to set up an employee benefit trust, which owns the stock on behalf of employees. The company funds the trust through cash, stock contributions or borrowing. ESOPs are governed by the same U.S. retirement laws that cover more common retirement plans such as individual retirement accounts, or IRAs. Similar to those plans, ESOPs grow wealth on a tax-deferred basis.
But whether an employee takes company stock as part of his or her compensation today or as a retirement benefit, similar issues arise in gauging the soundness of the investment, says Wendy Prestwood, a financial adviser with Prestwood Financial Group in Overland Park, Kan.
“Most employees don’t ask enough questions when they’re offered stock,” says Prestwood. “Each company and each plan is a little different, so you need to talk to your benefits department to really understand the potential upside as well as the risks.”
Stock ownership can have a potentially huge financial upside. But the value of employee stock plans isn’t the possibility of a financial windfall, says Nicholas Olesen, a wealth manager at The Philadelphia Group in King of Prussia, Pa. “One of the biggest benefits these plans give employees is the opportunity to invest in the company they work for through a systematic savings or deferral program,” he says.
It’s the systematic, long-term nature of these plans that can really generate wealth, Olesen says. And while some plans draw on employee contributions, having that money automatically deducted from your paycheck means you’re not likely to miss the cash or the opportunity to invest.
Another benefit to company stock plans is that they allow employees to invest without paying broker’s fees.
“If you think in terms of discount brokerages, it’s only a few dollars,” White says. “But remember, you’re buying a little bit of stock on a regular basis over a long period of time, so skipping those fees could be a big deal over the long haul.”
The biggest issue for employees is that when they buy or receive company stock, they aren’t diversifying their portfolios.
“They just have too many eggs in one basket,” Prestwood says. Sudden market changes can wipe out a nest egg just when the employee needs it the most.
As a general guideline, Prestwood says she wouldn’t advise a client to have more than 15 percent of his or her portfolio in company stock. But even that figure can be high, and she cautions that it’s crucial for employees to consider their specific circumstances as they would with the rest of their portfolio, their timeline for retirement and their future financial needs.
“And remember, if the company goes under, you’ll lose your job and the retirement money all at once, so you need to ask yourself what happens to your portfolio in that situation,” Prestwood says.
But even if you’re diversified, your company may not be a good investment, White says.
“You have to ask if you’d buy that stock if you didn’t work there. If the answer is no, it’s nice that your employer makes it available, but you may want to pass,” White says.
Assuming the company stock that the employee buys makes money, there eventually will be a tax bill, and it’s not a simple problem.
“Although ESOPs allow the employee to defer income, they also can add a significant amount to the employee’s taxes when they are vested or sold,” Olesen says. “As an employee’s base income should rise each year, adding income from an ESOP, especially if the underlying stock rises significantly, could move the employee into a higher tax bracket, cause them to be hit with alternative minimum tax, lose out on certain tax deductions and make them ineligible for traditional or Roth IRA contributions.”
Exercising stock options also presents its own set of tax issues. “Stock options can make an employee a lot of money, but the tax issues are very complex, and they’re going to vary significantly from person to person,” Prestwood says. “If you get stock options through your job, you definitely want to talk to an accountant.”
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