What to do with Sudden Wealth

Authors: Sam Maness & Jason Coleman

Cisco recently acquired local Ann Arbor cyber-security firm, Duo Security, via cash purchase for $2.35 billion. Tech start-ups generally provide early employees with stock options and restricted shares. The acquiring company will often purchase those shares during the sale, providing a substantial windfall for many employee-shareholders. This got us thinking about what to do when that big check hits your bank account. 

Our team works with a lot of investors that realize sudden wealth. This can take shape in many forms – inheritance, sale of a private business, appreciated equity compensation or private stock, or even a new professional career. New wealth provides new opportunities - but it also raises a lot of questions. Here is what we think about when advising clients receiving a substantial cash payment for the sale of private company stock. 

The acquisition usually answers many of the questions an employee has when owning private company stock: what are these shares worth? Will I ever see cash for them? What is the next step for the company?

At the same time, it creates an entire new set of questions: Will the management team be replaced? Does this change our company culture or strategic vision? Will my role stay the same, or change to better reflect the new company? Will I even keep my job? And if so, where will our office be located?

These questions are hard to answer, but they are important to think about when you realize sudden wealth. Many clients come to us with windfalls, curious about how to best utilize it to achieve their goals. They usually fall into a few different categories: (1) dream purchases or experiences, (2) upgrades to lifestyle, (3) real estate, and (4) investing or wealth creation. There are no right or wrong answers; the key is aligning your objectives in a way that provide value, whatever “value” means for you. Here are a few notes we have on each category:

Dream Purchases

What have you always wanted but couldn’t afford? This could be a boat, new car, jewelry, or world travel.

Pro: Dream realization, reward for hard work, personal happiness

Con: Diminishing return on happiness for new purchases, and ongoing expenses lead to significantly more costs in the long run for boats, cars, etc.

Lifestyle Upgrades

Here we are thinking about improvements to your daily life: an apartment upgrade, services like housecleaning or personal trainer, more travel/entertainment, etc.

Pro: Personal satisfaction/enjoyment, stress reduction, time freedom

Con: “Wants” become “needs” and you permanently increase your expenses. These costs can look inexpensive in the short-term but add up over time. Investing $2,000 monthly at 7% returns provides over $1.6 Million dollars after 25 years

Real Estate

We are talking about a primary residence - not investment property. Buying a home doesn’t fit neatly in to any one bucket and deserves more space than we have here.

Pro: Ability to relocate to a safer neighborhood or better school district, provides more space & privacy, your monthly payment builds equity over time, home value could increase over time, pride of ownership and personal enjoyment

Con: Long-term commitment, illiquid asset with high transaction costs if you have to relocate, “hidden” costs of taxes & maintenance, fixed expenses could be hard to cover if you have a change in circumstances

Building Wealth

Pro: Reduces stress around money and finances, provides more freedom to change careers or retire early, helps achieve long-term goals (college savings, retirement, etc.), and protects against unexpected changes in employment, health, etc.

Con: No immediate benefits or changes in your daily life, no additional ability to make purchases or have new experiences

What comes next?

We believe a key goal of unexpected wealth should be to provide a higher level of financial freedom. We can’t predict the future, but planning today will provide you more options tomorrow – regardless of what next for your career. We work with our clients to drive the conversation starting with the fourth bucket – investing and wealth creation – and working backwards through the list to provide opportunities for dream purchases or lifestyle upgrades. This shift in mindset is not always easy, but particularly for those under 50, the potential upside is extremely compelling when you consider the power compound interest can have when you front-load retirement.

These are hard decisions, and it is even harder to make objective comparisons on your own. Our team looks at potential financial outcomes over a lifetime of saving vs. spending, investing vs. upgrading, etc. – doing our best to achieve both short-term and long-term client goals. Working with a third party can help you identify blind spots, vet opportunities, and develop a plan.

Tax Planning*

Tactically, a financial windfall will of course complicate your tax planning. Many stock option proceeds aren’t taxed in the same way as salary & wages, bonuses, or other compensation. With stock, you generally only pay tax on the “capital gains” – the amount you receive in excess of the purchase price. For example, a stock purchased for $10 and later sold for $100 has $90 in capital gains. And timing is important for capital gains. 

For any stock held less than one year, you pay ordinary income on capital gains (sale price less the purchase price). These short-term gains are relatively easy to calculate for taxes – you simply add your gains to your salary/wages and other income to arrive at your tax liability. For stock you’ve owned for a year or more, long-term capital gains (“LTCG”) apply, and these are more complicated. 

Most investors pay a 15% flat rate on long-term capital gains, but not everyone. Taxpayers with lower income can receive 0% capital gains tax treatment and a higher income could mean a 20% rate. The 20% rates apply for single filers with adjusted gross income (“AGI”) over $425,800 and married filing jointly above $479,000 (you can view a copy of the 2018 rate chart here).  Importantly, even though capital gains are taxed differently, they are still included within your adjusted gross income. 

This means if your annual income includes $100,000 in salary and $400,000 in capital gains net of any deductions, your AGI is $500,000. This higher AGI pushes you in to the 20% tax bracket for long-term capital gains. It also subjects you to luxury taxes like the Net Investment Income Tax - an additional 3.8% tax on the lesser of (1) your net investment income, or (2) the amount by which your modified adjusted gross income exceeds:

• $200,000           (single or head of household)
• $250,000           (married filing jointly)
• $125,000           (married filing separately)

The following table uses very basic assumptions to provide tax liability projections under different stock awards, estimating $100,000 in ordinary income (after deductions). Please note that this doesn’t account for tax liability on other income, or for the Alternative Minimum Tax, a less common income tax regime that could apply to investors recognizing large capital gains. 

In many cases, estimating taxes and preparing in advance is the best way to protect yourself. Setting cash aside up front in a stable investment or savings account can alleviate a nasty surprise when you file in April. A team like ours can guide you through these decisions to better understand your options – contact us at 734-944-7556 or mclarenteam@raymondjames.com for a free initial consultation of your financial planning situation. Or check us out on the web at https://mclarenwealth.com/. 

*Disclaimer: You should discuss tax or legal matters with the appropriate professional.