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Financial Planning: Strategies

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Ten Financial-Planning Rules Everyone With Stock Options Needs To Know

Michael Beriss

Managing your stock options is one of the most complex financial challenges you will face. As an initial step in getting the most out of your company's stock plan, learn the following 10 rules.

Rule #1: Set Goals.

In granting you stock options (or restricted stock, or shares in an employee stock purchase plan), your company has given you what it hopes is a powerful motivation and retention tool. It wants you to understand the options' value and fit the stock into your overall plans. All financial planning should start with setting goals. What do you want to do with the proceeds from the eventual sale of the stock? Pay for the kitchen renovations in two years, Hilary's college in four years, Greg's wedding in 12 years, or retirement in 35 years? Reflecting on this will help you focus on your specific use of the stock in relation to your other income and savings.

All financial planning starts with setting goals. What do you want to do with the proceeds of selling the stock?

Rule #2: Develop An Overall Plan.

Determine how you will handle the stock options over time. Remain aware of your choices, the term of your options, and the tax and lost-gains consequences of your exercise decisions. Following the guidance in Rule #1, you need to exercise and sell at least enough stock to meet your goals. In addition, you may want to stagger the exercises and subsequent sales over a period of years to spread out the taxes. Alternatively, some studies have shown that holding options for the full term is the best way to maximize gains. If you simply decide at the beginning or end of each year whether or not to exercise and sell during the year, you may generate unnecessary taxes or lose opportunities when the price keeps rising. Plus, if you do not keep track of expiration dates, in-the-money options may expire unexercised.

Rule #3: Accurately Value Your Stock Options.

Tax intricacies can easily catch you by surprise. You may forget to discount the value of the stock option by either the exercise price or taxes. The option to buy at $50 per share 1,000 shares of your company's stock now trading at $100 may first appear to be the equivalent of a $100,000 investment (1,000 shares x $100 current price). However, in the end you may net only about $30,000 after paying the $50 exercise price and 40% in federal and state taxes combined. With the commonly granted nonqualified stock options (NQSOs), your company will probably withhold 25% federal taxes plus payroll and state taxes when you exercise your options.

Rule #4: Wait As Long As Possible To Exercise.

If the outlook for your company is good, don't immediately exercise the options. A traditional stock option gives you the right to buy stock up to 10 years in the future. Historically, stocks increase in value over time. By waiting, you enjoy all the upside leverage potential without any cash investment, and the spread between your exercise price and the rising stock price grows without taxation.

If stock options represent over 25% of your net worth, diversification may be more important than waiting.
For some tactics of this strategy, see a related FAQ.

Rule #5: When To Ignore Rule #4.

You should wait to exercise only if doing so meets your goals and needs. Should the stock options represent more than 25% of your net worth, diversification may be more important than waiting. In addition, your company may have stock ownership guidelines, or may just want to see you put more of your money at real risk in company stock, which would require you to exercise and hold the shares. Finally, if your company's stock is volatile, making the price swings personally hard to tolerate, you may want to exercise and sell earlier. (See a related article and FAQ.)

Of course, you cannot sell company stock when you know important inside information. Check into whether your company has blackout and preclearance trading rules that impact the timing of any stock sales. (For more on this topic, see the section SEC Law.)

Rule #6: Learn What Happens When You Leave Your Company, AND Tell Family Members.

Read the option plan and your grant agreement carefully. Know your rights if you're fired or if you quit, work for a competitor, retire, become disabled, or die. Many plans give you 90 to 180 days to exercise vested options after retirement and disability. This period can be shorter or longer. In addition, you may lose vested option gains immediately if you begin to work for a direct competitor. Make sure you, as well as your family or close friends, are aware of these rights. It's a shame when valuable options lapse without being exercised. See the articles and FAQs in Job Events and Life Events.

Rule #7: If You Have ISOs, Learn About AMT.

First, before you decide to exercise and hold the stock, double-check whether you have incentive stock options (ISOs) or nonqualified stock options (NQSOs). With NQSOs, when you exercise, you will owe tax at your ordinary income rate on the spread between the option exercise and market price whether or not you immediately sell the stock. However, with ISOs, when you intend to hold the stock for one year to qualify for capital gains tax treatment, you face a tax trap (see a related article).

If you ignore the risk of AMT, you may need to pay tax on paper gains from your exercise before you even have the money.

The biggest mistake you can make with ISOs is to forget or not know about the alternative minimum tax (AMT). The AMT rules require you to include the spread on exercise of ISOs in a calculation of alternative income, unless you sell the shares in the calendar year of the exercise. The messy AMT calculation adds back to your income a number of standard deductions (e.g., state and local taxes). It then multiplies this amount by 26% or 28%, according to the amount of your AMT income.

Should the tax on this amount be higher than under the standard rules, you pay the higher amount instead. As a result, at tax time you may need to indirectly pay the IRS on the the paper gains from your exercise before you have actually sold the stock to generate the money. If you do not have the cash when the tax bill is due, you may be forced to sell stock at the wrong time or face interest and penalties.

Rule #8: Determine Tax Rates And Watch Brackets.

Most stock options generate ordinary taxable income when exercised, either because they are NQSOs or because the ISO stock is immediately sold after exercise. Determine your tax rate so that you can plan for any estimated tax payments and analyze whether you want to take all the income in one year or spread it out over several years.

Example: Near the end of the year, your taxable income is about $50,000 below the threshold of the next tax bracket above yours, allowing you to receive up to an additional $50,000 of income and still pay income tax at your current rate. You have potential stock option gains of $100,000. However, if you receive an additional $100,000 in one year, the first $50,000 will taxable at your current rate, but the second $50,000 will be taxed at the higher rate of the next tax bracket. As a result, you may want to wait until the next year to exercise the second half of your options.

Rule #9: Focus On Vesting Rules And Dividends.

Some companies now grant options that are immediately exercisable but have resale restrictions that lapse over time (see a related article and FAQ). You will need to put up the cash to exercise and hold the shares after exercise, a strategy that may be attractive in pre-IPO companies where you expect a big price run-up. If you make a Section 83(b) form filing with the IRS within 30 days of exercise, you pay tax at ordinary income rates on the spread at exercise for NQSOs (for ISOs, the spread is part of your AMT calculation), then the gains at sale will be taxed at capital gains rates.

Similarly, if your company's stock pays a dividend, you may be better off exercising now and holding the stock to receive the dividend. This remains true even if you must borrow to buy the stock. You will end up ahead when the dividend generates more cash than the cost of borrowing. (See a related article.)

Rule #10: Get Good Advice.

When choosing an advisor, you should ask at least these two questions:

  • How often does the advisor work with stock options?
  • Can that person provide references from clients with options?

Michael Beriss is a Senior Financial Advisor at Ameriprise Financial (Bethesda, MD) and is on the advisory board of myStockOptions.com. This article was published solely for its content and quality. Neither Michael nor his firm compensated us in exchange for its publication.


People who read this article also read:
Top Ideas For Year-End Tax Planning With Stock Compensation (Part 1)
Better Late Than Never: Stock Option Strategy For The Market Upturn
Stockbrokers' Secrets (Part 1): What I Tell My Best Clients About Stock Option Strategy
Stock Option Fundamentals (Part 1): Know Your Goals And Terms