The stock market is anticipating a flurry of initial public offerings from high-profile companies over the next few months.
For some employees, owning a piece of the company pie has the potential to come with a life-changing amount of money. For most, though, while a significant windfall can buy some financial freedom, it’s unlikely to eliminate all financial concerns.
If you find yourself with a large amount of money in the wake of your company’s IPO or some other significant financial event in your life, arming yourself with the information to make smart financial decisions will be crucial to effectively managing your newfound wealth while avoiding common pitfalls.
Assuming that most of this wealth will be generated through some sort of equity compensation structure, the first thing you should do is study up on the intricacies of your company’s plan. The most important thing to know is the type of company stock or stock options you are receiving. There are many forms of equity compensation, such as nonqualified stock options (NSOs), restricted stock units (RSUs), stock-appreciation rights (SARs), performance stock options (PSOs) and employee stock purchase plans (ESPPs), to name a few, and each can come with its own vesting schedule and tax treatment. Your plan administrator can explain the details on your plan.
A vesting schedule is used to encourage employee loyalty, and it determines when you’re eligible to acquire full ownership of your shares. Depending on your plan’s schedule, you may not have access to this money as soon as your company goes public, and you may have to forfeit a portion of your stake if you leave your job before you’re fully vested. For example, your options may vest over the course of four years at the rate of 25% per year.
Prior to making any big financial decisions, make sure you understand how much of your equity compensation you possess at any time and how your vesting schedule works.
As you might expect, you will need to pay taxes on your new cash. The question is, how much? Equity compensation, including proceeds from an IPO, may be taxed as ordinary income or may receive favorable tax treatment, depending on how it’s structured. To avoid surprises, get an estimate of your tax liability from a tax professional and set that money aside in a relatively safe place, such as a savings account or money-market account.
Depending on the circumstances, you may also be responsible for paying estimated taxes for the year in which you receive the windfall, and those taxes may be significant.
With the basics squared away, you can focus on how best to deploy this influx of capital. Here are a few suggestions on how to set yourself up for success:
• First, pause and think. Suddenly coming into a large sum of money might tempt you to live out your shopping-spree fantasies. However, the short-term satisfaction of impulse buys and splurges may give way to regret down the line. Take a moment to assess your current wants against your future financial priorities. You may be able to budget for some items that enhance your quality of life now while still being mindful about how this money can help you achieve longer-term goals.
• Rethink your asset allocation. If you have a while to go before retirement, you’ve likely shaped your portfolio around the idea of building wealth for the future. After a big windfall, though, you may want to structure your holdings around wealth preservation to buffer against severe drops in the market. That might mean moving from an all- or mostly-stock portfolio to one that includes more fixed income or cash investment holdings.
Regardless of how you decide to allocate, the most important thing is that you diversify your portfolio, since much of your wealth may now be tied up in company stock. Markets are uncertain, so I typically recommend having no more than 10% to 20% of an investment portfolio allocated to one company, and that includes the company where you work.
• Be smart about debt. Eliminating outstanding consumer debt (like credit-card debt) and student loans makes sense. While you may be tempted to pay off your mortgage, that may not be the best move, particularly if you financed during the stretch of ultra-low interest rates. High-interest loans should take priority over low-interest loans because time is on your side to pay back the latter. Also, if you are thinking about buying a new home, be mindful that the new tax code has lowered the amount of mortgage interest you can deduct.
• Reassess your insurance needs. If you have life insurance primarily to replace your income and support your family, your new wealth may mean that is no longer necessary. If there is a possibility that your additional wealth could make you a financial target in the event of a lawsuit, you may want an extra liability policy, or an umbrella policy.
• Finally, think about what’s really important to you. Once you’ve taken care of the practicalities, it’s time to start thinking about how this new income might help you fund important life and career goals, like starting your own business, launching your own creative project or exploring a new direction for your retirement. Choice may be the true luxury that a windfall affords.
This is also an opportunity to update your charitable-giving strategy. A donor-advised fund, for example, can allow you to claim an immediate tax benefit, and you can decide how to allocate the donated money over time.
Being part of an IPO is an exciting moment, and while it may give you a sense of security, a sudden surplus of cash could also trigger hasty financial decisions. To avoid making costly mistakes, seek the help of a financial advisor. A professional can help you take a holistic approach to financial planning and develop a strategy for the present and the future, with the ultimate goal of ensuring that your newfound wealth lasts a lifetime.
Amy Reback is vice president of Schwab Stock Plan Services, which provides equity compensation plan services and other financial services to corporations and executives through Charles Schwab & Co., Inc.
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