Many people’s compensation is limited to a paycheck that hits their bank account weekly, every two weeks, once a month, or at another cadence. But if you work for a public company, you may receive a combination of cash and shares of its stock as compensation.
This isn’t necessarily a bad way to get paid. When you receive a $100,000 salary, that’s all you’re getting — $100,000. When you receive $80,000 of your salary in cash and the remaining $20,000 in stock, over time, that $20,000 in shares could grow to be worth $25,000, $30,000 or more.
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On the flipside, when you’re paid in stock, there’s a chance that your shares will lose value over time. So in that regard, you’re taking a risk, which is probably a pretty obvious drawback of this compensation model. But getting paid in stock has the potential to backfire on you for a less obvious reason, too.
When your portfolio is no longer well diversified
You’ll often hear that it’s important to maintain a diversified portfolio because doing so can not only lead to solid growth over time, but protect you from excessive losses. The problem with being paid in stock, though, is that if you keep accumulating shares of the same company, eventually, they might comprise a very large chunk of your portfolio.
That could lead to a huge imbalance. And it could also prove problematic if those share prices then take a dive.
Let’s say you’re issued 10 shares of Company X each month as part of your compensation. When you first start out, the 10, 20, or 30 shares you have might comprise just 3% or 4% of your brokerage account’s investment mix. But in time, as you continue to collect those shares, they might eventually account for 20%, 30%, or 50% of your portfolio.
Meanwhile, let’s say your total stock portfolio eventually grows to be worth $100,000. If you have 50%, or $50,000, of your portfolio in Company X and its share price falls by 20%, you’re suddenly looking at a portfolio value of just $90,000, or a $10,000 hit. That’s a pretty big decline. If Company X only makes up 10% of your portfolio, or $10,000, a 20% drop in its stock price would constitute a $2,000 hit to your total portfolio instead.
How to keep your portfolio nicely balanced when you’re paid in stock
If you work for a company that pays you partially in stock for many years, you might eventually accrue a large number of shares. So what you’ll need to do is figure out what percentage of a single stock is too high for your taste and make plans to unload shares accordingly.
Some people may be okay with a single stock comprising up to 20% of their portfolio. Others may be more comfortable limiting that percentage to 5% or 10%.
Once you land on the right number for you, you can start selling shares of your stock once they’ve been in your portfolio for at least a year and a day. That way, you’re looking at long-term capital gains taxes on your profits, as opposed to short-term gains, which apply to investments held for a year or less. Long-term capital gains are taxed a lot more favorably, which means you’ll pay the IRS less money on your profits.
Of course, capital gains taxes are only a problem if you’re selling shares at a profit. But ideally, that is what you’ll be doing.
Being paid partly in cash and partly in stock isn’t all that uncommon. But make sure to manage your investments accordingly under that setup so you don’t wind up with a portfolio imbalance that causes problems. And if you decide that it’s time to start unloading some of your company’s shares, time those sell-offs strategically to minimize the tax blow.
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Work for a Company That Partially Pays You in Stock? Beware This Pitfall was originally published by The Motley Fool