Top 10 Financial-Planning Rules Everyone With Stock Options Needs To Know
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If you've been granted stock options, congratulations. Stock options give you a potential share in the growth of your company's value without any financial risk to you until you exercise the options and buy shares of the company's stock. Moreover, while cash bonuses and most other forms of compensation are taxable when you receive them, stock options defer taxes until you exercise them. Before you exercise your options, their built-in value is subject to pre-tax growth—which can be significant.
However, maximizing the value of 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, consider the following guidelines. (See also the articles on financial-planning guidelines for restricted stock and RSUs and for ESPPs.)
Rule No. 1: Set Goals
In granting you stock options or restricted stock, or the right to buy 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.
Rule No. 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 No. 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 No. 3: Accurately Value Your Stock Options
The intricacies of option taxation 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 22% for federal taxes plus payroll and state taxes when you exercise your options.
Rule No. 4: Wait As Long As Possible To Exercise
If the outlook for your company is good, don't immediately exercise the options, especially if they are NQSOs. 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.
For some variations and alternatives to this strategy, see a related FAQ.
Rule No. 5: When To Ignore Rule No. 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 must not sell company stock when you know confidential information about the company that, if public, would affect its stock price. Called insider trading, that is illegal because it gives you an unfair advantage over other investors. Insider trading get you into serious trouble. Your company may also have its own rules, such as blackout and window periods for trading or preclearance requirements, to prevent insider trading. These may affect the timing of your stock sales or temporarily prohibit you from trading the company's stock at all. (For more on this topic, see this website's FAQs on insider trading and on blackout and window periods for trades.)
Rule No. 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 are fired or if you quit, work for a competitor, retire, become disabled, or die. Many plans give you no more than 90 days to exercise vested options after job termination for retirement or disability, though the post-termination exercise period can be longer. However, you may lose vested options immediately if you leave the company to work for a direct competitor. Make sure you, as well as your family or close friends, are aware of these rights. See the articles and FAQs in Job Events and Life Events.
Rule No. 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. But with ISOs, if you intend to hold the stock for one year from exercise and two years from grant to qualify for capital gains tax treatment for the full gain over the exercise price, you face a tax trap (see a related article).
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 No. 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 No. 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 No. 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, restricted stock and RSUs, or ESPPs?
- Can that person provide references from clients who have stock compensation?
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.