Stock compensation planning: Why waiting is often the most expensive strategy

Editor: Lincoln Fleming, CPA/PFS, M.Acc.

Stock–based compensation has become one of the most significant — and misunderstood — components of compensation packages, particularly for employees of publicly traded companies. Over the years, I have worked with a wide range of clients who receive compensation in the form of incentive stock options (ISOs), nonqualified stock options (NSOs), and restricted stock units (RSUs). These clients range from early–career professionals to senior executives, many of whom have accumulated substantial wealth on paper but remain uncertain about how, when, or even whether to act.

What continues to surprise me is not the complexity of the compensation itself but how little intentional planning often surrounds it.

Despite the sophistication of the companies issuing these awards, the planning around stock compensation is often surprisingly limited. In practice, I tend to see two default strategies repeated over and over again:

• Doing nothing until the last possible moment, often waiting until stock options are close to expiration before exercising them; or
• Exercising or selling immediately upon vesting, converting equity compensation into cash as soon as it becomes available.

Both approaches are understandable. The first is frequently motivated by a desire to delay taxes for as long as possible. The second is driven by prudent concerns about diversification and risk management. However, in my experience, both strategies are often adopted without a full understanding of their tax consequences or how they align with the individual’s broader financial goals.

The reality is that stock compensation planning is not a single decision but a series of interrelated choices involving taxes, investment risk, cash flow, and long–term objectives. When approached proactively, these decisions can materially improve after–tax outcomes and reduce avoidable risk. When ignored, they often lead to higher taxes, missed opportunities, and unnecessary stress.

This column focuses on common planning mistakes and more thoughtful alternatives, with particular emphasis on stock options and RSUs. While the specifics of any strategy depend on individual circumstances, the underlying principle is universal. Planning ahead creates flexibility, and flexibility creates value.

The cost of waiting until expiration

One of the most common approaches I encounter is the decision to wait until stock options are near expiration before exercising. The rationale is straightforward. Exercising earlier may trigger taxes, so delaying the exercise delays the tax bill. In practice, this often proves to be a costly form of procrastination.

Waiting until expiration is similar to burying one’s head in the sand and hoping that an unavoidable issue — taxes — will somehow resolve itself. Taxes do not disappear simply because the exercise is delayed. Instead, the decision to wait frequently compresses what could have been a multiyear planning opportunity into a single high–tax event.

By deferring action, employees give up several important advantages:

• The ability to control the timing of income;
• The opportunity to shift future appreciation into capital gains;
• The flexibility to spread tax liability across multiple years; and
• The chance to align exercises with liquidity planning.

When options are exercised at or near expiration, the accumulated gain is typically taxed all at once, often at ordinary income tax rates. For many clients, this results in a significant and unexpected tax burden, frequently coinciding with other high–income events such as bonuses or liquidity transactions.

A more proactive alternative: Exercising earlier

For clients whose company stock is appreciating and who believe in the long–term prospects of the business, exercising options earlier, often at vesting, can offer meaningful tax advantages.

Example: An employee receives stock options with an exercise price of $10 per share. At vesting, the stock is trading at $20. If the employee exercises at vesting, the $10 spread may be subject to ordinary income tax in the case of NSOs or alternative minimum tax (AMT) considerations in the case of ISOs. From that point forward, any additional appreciation is generally taxed as capital gains when the shares are eventually sold.

If the stock later appreciates to $50 per share, the $30 increase from $20 to $50 may qualify for long–term capital gains treatment. By contrast, waiting until expiration and exercising at $50 may cause the entire $40 spread to be taxed at ordinary income rates.

Balancing tax efficiency and risk

Exercising earlier can increase concentration risk if the employee holds the exercised shares instead of selling them. Holding the company’s stock in this manner increases exposure to a single issuer, often the same company that provides the employee’s salary and benefits. This concentration risk should never be ignored.

However, tax efficiency and diversification are not mutually exclusive. With proper planning, clients can strike a balance between the two, by:

• Exercising a portion of options each year;
• Targeting exercises in lower-income years;
• Combining early exercise with a planned selling schedule; and
• Coordinating exercises with charitable or gifting strategies.

ISOs: Opportunity and complexity

ISOs introduce additional complexity, particularly due to the AMT. Many clients are reluctant to exercise ISOs early because of concerns about triggering AMT. In practice, AMT exposure can often be modeled and managed, partial exercises can limit exposure, and AMT paid may generate future tax credits. These AMT concerns are not present with NSOs and RSUs, which are taxed differently from ISOs.

The exercise and immediate sale strategy

Some employees choose to exercise and sell immediately upon vesting. This approach eliminates concentration risk and simplifies tax reporting, but it also forfeits the opportunity for capital gains treatment on future appreciation.

RSUs: A different planning challenge

RSUs are taxed as ordinary income upon vesting, regardless of whether shares are sold or held. As a result, planning focuses less on tax timing and more on portfolio construction and concentration management.

Concentration risk and behavioral bias

Employees often hear optimistic projections about company stock from leadership. Even when accurate, these views are rarely unbiased. When income, benefits, and investments are all tied to the same company, adverse outcomes can be magnified.

Aligning stock compensation with goals

The most effective stock compensation strategies are those that align with broader financial goals. Planning ahead allows clients to coordinate equity decisions with retirement planning, charitable strategies, and cash flow needs.

Managing with intention

Stock compensation is one of the most powerful wealth–building tools available to employees, but only when it is managed intentionally. In my experience, the greatest cost is not the taxes paid but the opportunities missed by failing to plan ahead.

Contributors

Wesley Botto, CPA/PFS, CFP, is a financial planner with Hillcrest Financial Group in Cincinnati. Lincoln Fleming, CPA/PFS, CFP, M.Acc., is a director and after-tax wealth strategist at BlackRock. For more information about this column, contact thetaxadviser@aicpa.org.