Incentive Stock Options (ISOs) are one of the most complicated forms of employer stock compensation.
In this podcast episode, I discuss the basics of ISOs, how they function from a tax perspective and some major pitfalls to be aware of. One of the most common pitfalls people neglect is looking into potential alternative minimum tax (AMT) exposure when they exercise lucrative ISOs.
This happens when you are attempting to hold two years from the grant date and one year from the exercise date to benefit from long term capital gains. This can be a good strategy if you believe the share price will continue to rise and you want to reduce your tax liability.
However, the difference between the strike price and the fair market value of the stock on the day the option is exercised (known as the bargain element) is a tax preference item for calculating AMT.
Depending on how large your ‘bargain element’ is, you could be opening yourself up to a large AMT liability. You must be aware of this so that you’re not stuck with a massive tax bill come tax filing time (and have to find the cash on hand to pay it).
There’s a balancing act when it comes to divesting from concentrated stock positions via an ISO while being mindful of the tax implications.
In this episode, I also discuss the fear of missing out (FOMO) as it relates to owning employer stock (or any concentrated position for that matter), and why I’m a fan of regret minimization.
Anytime you’re selling off a concentrated position, there is an opportunity cost (which I like to refer to as investing FOMO). There’s always the chance that your stock (in this case employer stock) takes off and vastly outperforms the broader market.
However, you have to consider the downside as well, and that the individual security can massively UNDERPERFORM the overall market. You must have a long term financial plan that factors in your complete financial picture to determine whether you should (or need) to be taking on concentration risk.
ISO compensation is one of the most common windfalls I see. Especially, when you’re compensated from a private company that goes public, there’s the potential to become an ‘overnight millionaire’.
If you’ve experienced that ‘pop’, I discuss different ways to approach diversifying depending on your short and long term goals.
At what point in your business’s lifecycle are you? Are you at the point where reinvesting in your business (increasing employees, equipment, etc.) provides diminishing profit returns? If so, consider creating a financial fortress outside of your business so that you are NOT dependent on your business to supplement your lifestyle.
When you create a business, it’s your baby (I get it). It’s easy to get sucked into your business and reinvest 100% of every dollar you generate to grow your business. And if you’re creating a scalable product or service, maybe that’s the right decision (personal finance rules don’t apply to entrepreneurs). However, if you hit a wall (cannot scale further) or are at a point where you are paying yourself an amount that you’re happy with, consider fortifying your personal finances.
In this podcast episode, I discuss some of the pitfalls of becoming overly dependent on your primary business. Especially businesses where there may be little (or no) market value if you were to sell the business, why it’s important to fortify your personal finances sooner rather than later.
How susceptible is your business to changes in the health of the economy? What would happen if your business suddenly came to a halt? These will vary depending on your type of business but are important questions to ask yourself.
One of the first steps in creating a fortress around your business is creating a separate business entity that protects your personal assets from any potential financial and liability claims. The type of business entity you select (such as an LLC, S-Corp, or Partnership) will depend on the number of owners (and employees) you have, and how you want your business to be taxed (flow-through, dividend, etc.).
Once you’ve fully separated your personal assets from your business assets, you must pay yourself an appropriate amount from the business. You want to make sure that you’re keeping the cash flow of the business separate so that you can accurately keep track of tax liability and not compromise your liability benefits of having a separate entity.
As a business owner, you should be paying yourself for the risk you take on and the hard work you put in. Even if the business is self-sufficient, you should be reviewing the amount you are paid so that you can build financial independence outside of your business.
While it’s not uncommon for successful business owners to be dependent on their business to supplement their lifestyle, there may come a time when they’d rather not carry that burden. Depending on the revenues of your business and how transactional they are, you may or may not have as much equity in your business as you believe (if you were to sell). This is another reason why fortifying your personal finances sooner rather than later is a smart move.
“Give me six hours to chop down a tree and I will spend the first four sharpening the axe.”
― Abraham Lincoln
If you’re looking to set yourself up for long term financial success, you must take the time to put systems in place to quickly grow your net worth. Preparation is essential so that you can take advantage of your hard-earned money! To make the process easier, here are 5 steps to prepare for financial success:
1: Automate Your Financial Life
Take the time to establish a high yield savings account separate from your everyday checking. Look into establishing retirement accounts such as Roth, Traditional, and SEP( if self-employed) IRAs, even if you’re not quite ready to start utilizing them. Keep in mind you can still utilize IRAs in addition to your employer-sponsored retirement plan.
Long term you should strive to take advantage of all tax-deferred accounts (individual goals permitting) before moving on to taxable investing. By having the appropriate accounts in place (with bank links etc.) you can make it easy on yourself to make investment contributions in an efficient and timely manner. You can also work on simultaneously building up your cash reserve (anywhere from 3-12 months living expenses depending on the individual) so that you can invest with confidence later. Logistics is half the battle with taking action, so make it easy on yourself!
2: Pay Down Debt Strategically
In line with automating your financial life, take the time to review your debt (such as student loans). As a crucial no brainer, make sure you are allocating your debt repayment to the highest interest debt first. There are different ways to approach paying down debt, such as the debt snowball repayment method. While the specific strategy can vary depending on the individual, the most important thing is you have SOME kind of a plan and are making a conscious effort. The worst thing you can do is avoid looking at it because of the temporary stress involved.
3: Use a Credit Card Like you Would a Debit Card and Build Credit
Credit cards are useful as an intermediary between you and the vendor, especially in cases of fraudulent activity. It’s easier to correct fraudulent charges with a credit card versus a debit card (since it’s technically not your money), which is why you should not use your debit card for daily purchases. You can also earn rewards for purchases you would otherwise make anyways, so it makes sense to take advantage of credit cards! Credit cards are also a secondary cash reserve (hopefully to your actual cash reserve) which can be used for TRUE EMERGENCIES.
Paying off your credit cards on time along with having larger lines of credit (and not utilizing greater than 30% of them) will help build your credit score (fairly quickly too). Having a good credit score is especially useful when you are looking to qualify for a mortgage. With all of this being said, you should treat your credit card like your debit card. This means not spending more money than you’ve budgeted (or have in the bank, circumstance permitting). If you’re paying off your credit card monthly (which you should to avoid the outrageous interest rates), then it’s essentially a debit card with added benefits.
4: Budgeting: Start With Your Necessary Fixed Expenses and Figure out how Much you Have Left
It’s crucial that you at least KNOW what you’re spending. Consider using an online aggregation tool to track your total outflow. You cannot modify your budget if you don’t know what you’re spending. When building out your budget, start by looking at unavoidable fixed expenses you have to pay. From there you can determine what your variable discretionary expenses are. When you have a realistic analysis with yourself of what you are taking home for income (on an after-tax basis) less your outflow, you can figure out what your wiggle room looks like. If this is an area you struggle with, consider working with a financial coach such as Savings Academy.
5: Always Take Advantage of Free Money Even if you Have Limited Cash Flow
Does your employer offer a match on your 401(k) if you contribute a certain percentage of your salary? If so, you should contribute enough to at least receive the full match (even if your cash flow is tight). Free money is the best money. An employer match is essentially a 100% risk-free return (dependent on the match amount). That is hard to find!
Additional free money can come in the form of stock purchase plans where your company allows you to buy its stock at a substantial discount (and then immediately sell at the end of the purchasing period). Taking advantage of a stock purchase plan is not as straight forward as a 401(k) match, but cash flow permitting it can be a great source of “free money”.
Today (October 10th) marks my official 1-year mark since I launched my financial advisory practice, Modern Wealth Builders, LLC. It’s crazy how QUICKLY a year goes by and how much you can change in one year.
This last year forced me to learn more about myself than any other experience I’ve ever had. It made me get out of my comfort zone to try things that probably made me look silly at times, but are ultimately necessary to learn what does and doesn’t work. BELIEVE ME, when I say, I have by no means ‘figured it out’, but I have some valuable lessons to share with you about building a business. Especially businesses that involve ‘complex sales’ where YOU are the product (the service you provide).
Here are my FIVE biggest takeaways:
No one cares about how passionate you are about your service (and/or product). You need to make them the hero of the story.
I’m still guilty of this, but I’ve gotten better at it. People don’t care about what you’ve done, you’re accomplishments, etc., it’s about what you can do to help them with their specific pain point.
You can’t be everything to everyone. You’re naturally going to rub some people the wrong way and that’s ok.
Anytime you put yourself out there, whether, for business or personal reasons, you’re going to rub some people the wrong way. Especially people that don’t know you. The truth is polarization helps build brands and drive engagement (as long as it’s authentic), so embrace the trolls.
In-person networking in the business of complex sales is the best way to get started.
Even though we live in a digital age where google search engine optimization can make or break a business, I still believe in-person networking is powerful. With so much competition from big brands to grab our online attention, the personal touch of face to face networking is vital for building trust and establishing credibility. I neglected this early on.
Never get too high, never get too low.
This applies to ANY business. No matter how good your product or service is, there will inevitably be randomness that is out of your control (whether good or bad). Give yourself less credit when things are going well, and less blame when things aren’t. These things tend to even out over time, as long as you’re being consistent, it should come together.
It’s ALWAYS harder than it looks.
Before I went off on my own, I would look at other independent advisors and think, “that’s easy, what are they even doing”. It’s easy to throw stones when you haven’t been in the other person’s position (I used to do it). There’s way more that goes on behind the scenes, AND (again) you have to put yourself out there (at least a little) if you want to build a brand. This is what the “faceless twitter trolls” don’t understand. I know they’ve never built a financial advisory business from scratch because if they had, they’d have more respect for the independent advisors who ARE putting themselves out there to grow their business. Like most things in life, it’s about perspective. Turns out when you get to know someone, you usually end up liking them. Hate feeds on a lack of exposure.
The last lesson (dammit I guess I had six) I’ll share with you is the ‘process mentality’. You have to ENJOY the process or else you probably won’t last. This is because (especially in a service-based business) there really is no ‘destination’, therefore you better learn to love the JOURNEY.
“Let’s say you spend around $100 on coffee each month. If you were to put that $100 into a Roth IRA instead, after 40 years the money would have grown to around $1 million with a 12 percent rate of return. Even with a seven percent rate of return, you’d still have around $250,000.”
“You need to think about it as: You are peeing $1 million down the drain as you are drinking that coffee,” Orman says. “Do you really want to do that? No.”
What Suze Orman is referencing here is known as the ‘Latte Factor’ made famous by New York Times bestselling author David Bach.
Being cognizant of the small purchases in life and how they can lead to wasting substantial sums of money is IMPORTANT. Especially for someone just starting their personal finance journey and looking to build a solid foundation. However, to achieve meaningful wealth I don’t believe the “latte factor” is ultimately going to move the needle (unfortunately).
The major purchases in life such as a car, home, and education have opportunity costs that are worth a lifetime of latte purchases. So while I respect the principles of the latte factor, I don’t like the hyperbolic examples used by personal finance ‘gurus’ to draw attention to unrealistic examples.
More specifically, I REALLY don’t like the example used by Suze Orman in this article. A 12% annualized return is well above the long term average for US stocks and would be extremely unlikely to be achieved even by professional money managers. As you can see, the rate of return (over a 40 year time period) has a MASSIVE impact on the ending dollar amount.
The ending dollar value also doesn’t account for inflation! When you use realistic numbers that account for REAL returns after inflation, this example quickly loses its ‘clickbait’ appeal.
If foregoing coffee purchases aren’t going to move the needle, what will?
Again, assuming you are aware of and respect the latte factor, here are some things that have an opportunity cost that surpasses a LIFETIME worth of latte purchases:
Failing to plan for tax efficiency within your income and investments
Not maximizing lucrative employer stock compensation (such as options and purchase plans)
Failing to take advantage of 401(k) matches
For business owners – failing to reduce taxable income via retirement plans and available deductions
Overextending yourself on a home (residence) and/or viewing it primarily as an investment
Taking out student loans for education without a reasonable return on investment
Not discussing finances with your partner, which can ultimately lead to divorce
To really benefit from compounding interest with REALISTIC rates of return it requires a high savings rate. The ‘easiest way’ to achieve a high savings rate is by increasing your income. Foregoing the $5 latte will give you a great foundation, but will not ultimately move the needle (like increasing income will).
Don’t ever sell yourself short! Your earning potential is usually much higher than you think. Be cognizant of the small purchases but focus on getting the big-ticket decisions right.
Tune in to the DO MORE WITH YOUR MONEY podcast below to get my complete thoughts!