Stock options present unique challenges, opportunities, and potential pitfalls to personal finances. In addition, they’re inherently complex when considering other factors of an individual’s or family’s holistic financial plan. Over the years of working directly with people who receive stock options as part of their compensation package, we’ve come up with our four best pieces of stock options advice that I’ve outlined below.

Employee stock options are a common benefit in the tech industry. Not only do they incentivize employees to stick around, but employees benefit directly from their hard work in the form of ownership in company stock. Understanding stock options and how to incorporate them into your financial plan is a whole other story. For some individuals, their stock can become a large portion of their net worth as they can be extremely lucrative. This article will describe the basics of non-qualified stock options and incentive stock options, risks involved, and how to manage the tax consequences.

Before we dive into the details of non-qualified and incentive stock options, it’s important to understand the key terms often associated with them.

Key Terms to Understanding Stock Options

Grant Date: Typically, a company offering employee stock options will have grant dates for employees. Ownership isn’t given to employees straight out of the gate, they require a certain amount of time at the company before they’re granted.

Vesting: The date that the granted options “vest”, is when you gain full control of the options. Once vested, you’re able to choose when to “exercise” the right to buy your employers stock. The vesting schedule differs among employers, with some using a cliff, and others using a graded schedule. For example, a cliff schedule would vest all the granted options after 3 years, and a graded schedule would vest the granted options over a period of 5 years.

Exercise Price: The price at which you have the right to buy the stock once it’s vested. What makes stock options valuable, aside from the fact you’re getting additional compensation in the form of stock, is the “bargain element” received when you exercise. The bargain element is the difference between the exercise price and the market value of the stock at the time of exercising. For example, you may have a stock option that gives you the right to buy your employers stock at $10 per share, while the actual price of the stock is $20. That’s an immediate profit of 100% (not factoring in taxes).

Expiration Date: The date at which stock options expire. At some point, if you don’t exercise your options you’ll lose the right to buy the stock at the exercise price and the options disappear.

Types of Employee Stock Options

1. Non-Qualified Stock Options (NSO)

• NSO’s are generally offered to non-executives or key persons of a company.
• Granting of NSO’s is not a taxable event.
• Ordinary Income owed at the time of exercise on the “bargain element”, or the difference between the exercise price and the stocks current market price.
• When the stock is eventually sold, you pay capital gains taxes depending upon the amount of time you held the stock since exercising it. If held for less than 1 year you’ll owe ordinary income tax, and if held for longer than 1 year, you’ll pay the more favorable long-term capital gains rate.

2. Incentive Stock Options (ISO)

• ISO’s are generally offered to executives and key employees of a company.
• Granting of ISO’s is not a taxable event.
• Exercising ISO’s is not a taxable event. However, the dreaded AMT tax can apply to the “bargain element” of the exercised stock.
• When the stock is eventually sold, you pay capital gains taxes depending upon the amount of time you held the stock since exercising it. If held for less than 1 year you’ll owe ordinary income tax, and if held for longer than 1 year, the more favorable long-term capital gains rate. However, you also must ensure it’s been two years since the stock was granted to qualify for long-term capital gains.

How Do Stock Options Fit into My Financial Plan?

If you’re fortunate enough to receive stock options as a benefit through your employer it’s important to determine how they’ll fit into your overall financial plan. In order to maximize their benefits, you have to consider taxes, the stock’s value, and the risk you’re willing to take.

Taxes

Taking advantage of long-term capital gains rates compared to ordinary income can help reduce the tax consequences of the stock options. That is if you’re willing or able to open yourself to the potential risk of holding a concentrated position for a longer period of time. The difference between paying ordinary income tax and long-term capital gains can be significant, especially for individuals in the highest marginal income tax brackets.

NSO’s upon being exercised is recognized as ordinary income. As a result, it can push individuals unknowingly into a higher tax bracket if their bargain element is great enough. Weighing the pro’s and con’s of doing so is an important consideration to make when exercising NSO’s.

ISO’s can potentially expose you to AMT taxes, the parallel tax code. The way the IRS views ISO’s is they’re essentially giving away the bargain element (the difference between exercise price and current market price of the stock) tax-free. In order to ensure people pay taxes on that compensation, they include it in the AMT tax. Consulting with a tax advisor or financial planner prior to exercising a substantial number of ISO’s can help you navigate the AMT tax.

Stock’s Value

When determining whether to exercise stock options you want to determine the future prospects of the stock itself. If the current market value of the stock is similar to or less than the exercise price, you probably won’t be exercising the option.

Depending on the expiration date of your options, you have time to wait and see how the stock performs. Remember, once the stock option is vested, you maintain the right to purchase the stock at the exercise price until the expiration date. If the stock performs better and rises above your exercise price, then you may consider exercising, especially if the long-term growth prospects are favorable.

Concentrated Stock Risk

With both types of stock options there lies a common risk. Stock option plans can create substantial wealth. What’s important to understand is the risk involved when that wealth is created. Individuals can end up with concentrated stock positions from their company. Not only do they rely on the company for income, health benefits, etc, but a large portion of their net worth ends up in the company stock. If something were to happen to the company, it could be catastrophic for an individual with concentrated risk.

The key is to diversify. Oftentimes, there remains an emotional connection to the stock. The company you’ve worked hard for has rewarded you with ownership and it’s built you great wealth! It’s a natural reaction. However, when it comes to investing you have to try and separate the emotional connections, from what you’re truly presented with as it relates to your financial plan and goals. For example, what if your financial advisor recommended you buy one stock that represents 50% of your net worth? Not that they would ever do that, but it represents the same situation from an analytical perspective. Whether the stock was bought using stock options or cash in a brokerage account, having 50% of your net worth tied up in one stock represents a substantial risk.

Diversification doesn’t necessarily mean you’ll earn less in return either when compared to a concentrated stock position. What it does mean- is your investment returns are being maximized for a given level of risk.  Having a stock sell-off plan that manages the tax consequences in addition to diversifying over time is a key component of a financial plan that includes stock options.

Do you receive stock options as part of your compensation? Not sure how they fit into your financial plan or need help putting together a comprehensive financial plan in the first place? Schedule a free consultation with us today, and we’ll help you understand stock options and how they can help you reach your financial and life goals!

How to Make the Most of your Stock Options

There are four main ways you can ensure that you make the most of your stock options.

1. Calculate Tax Implications

Perhaps the most significant pitfall when it comes to exercising stock options is unexpected tax implications. Imagine exercising your incentive stock options (ISO’s) last year, submitting all your tax documents (including form 3921 – reporting the exercise of ISO’s), and your CPA informing you of a five-figure tax liability. To make matters worse, often, ISO’s (in pre-IPO companies) aren’t liquid; therefore, the exercise itself can’t pay for the tax liability. Instead, the individual must have an alternative source of funds to pay for the significant tax liability imposed by exercising the ISO’s.

Naturally, this can cascade, and scrambling to come up with the funds or depleting your emergency fund entirely is not out of the question. However, this can ALL be avoided by doing some careful tax planning work with a financial planner. We’ll help outline, before the exercise of the ISO in this case, what the potential tax liability is using assumptions with income and tax withholding for the remainder of the year.

Non-qualified stock options (NQSO’s) can also present a tax challenge, though, in most cases, not as significant. NQSOs are often used as a compensation benefit in companies that’ve already IPO’d; therefore, the company’s shares are much more liquid. There are cases where pre-IPO companies still provide NQSOs, but the options remain illiquid after exercise. Thus, taxes will be withheld if you can immediately exercise and sell the stock options’ underlying shares. Most often at a rate of 22%, which may or may not be enough depending on where your income for the year ends up.

Planning will avoid the sudden and potentially unexpected significant tax liability, ensure adequate liquidity sources to pay for the pending tax liability, and ultimately ensure that exercising stock options in any given year is best for your overall financial plan.

2. Sell or Hold?

It’s a question nearly everyone asks, should we sell our exercised stock options or hold the underlying shares? Of course, assuming that you can sell the shares immediately after the exercise, this may not be the case for pre-IPO company shares.

Perhaps the best way to approach this question is with another question. If you had X amount of cash equal to the leftover value of shares from the exercise, would you choose to purchase that same amount of company stock and hold it? After the exercise, you should sell the underlying shares if the answer is no. However, they’re essentially the same scenario if you chose to keep the underlying shares and hold them since there are no further tax implications to consider (again, ISO’s are slightly different if exercised and owned through calendar year-end). It’s as if you had purchased those shares with your equivalent cash.

If the answer is yes, you would purchase that amount of company stock if you had X amount of cash. It’s time to consider whether it’s a “smart” investment decision relative to diversification. If the leftover shares make up more than 10-15% of your overall investment portfolio, you’ll be taking an outsized risk according to diversification and modern portfolio theory rules. So, consider selling at least enough shares to ensure your portfolio remains appropriately diversified. Of course, this assumes that the company and stock appear to be suitable long-term investments.

3. Consider the Timing of Exercises

If you receive stock options as part of your compensation, you’re likely receiving new grants annually. This means that vesting periods are staggered based upon when the options were granted; therefore, your timing of exercises can or must be at different times. Again, this presents a planning opportunity as it relates to taxes and other potential time-relevant items with stock options. For example, ISO’s are only taxed at AMT rates when exercised and then held through the calendar year’s end. If you exercise stock options on January 1st and keep them until January 1st of the following year, you will potentially be exposed to the AMT tax brackets. If you exercise January 1st but sell the underlying shares on December 31st of the same year, AMT will no longer apply. Still, you will potentially owe taxes using ordinary income tax brackets. Therefore, it’s best to exercise ISO’s early in the year for the maximum flexibility regarding taxes since you’ll be able to pivot from ordinary income to AMT until the last day of the calendar year.

On the other hand, let’s say you’ve completed careful tax planning with your financial planner at year-end. It’s been decided that the following year will include a massive uptick in income. Therefore it’s more advantageous to exercise the non-qualified stock options this year (due to income taxes being much lower this year), resulting in fewer overall taxes being paid in the multi-year planning scenario. Or, the opposite could be true. Perhaps you plan on taking a hiatus from work, and income is expected to be dramatically lower next year; it likely makes more sense to hold off on the exercise and sale of the stock options until next year, when taxes will be lower.

4. Exercise When Bargain Elements Are Lower

The bargain elements allude to the spread between the fair market value of the stock when exercised and the cost (strike price or exercise price) to exercise the option. The bargain element is ultimately used to calculate the potential tax consequences of the exercise. When the spread is lower, there will be fewer taxes owed than when it’s higher. Of course, when it’s higher, the stock has appreciated more since you received the stock option grant. However, depending on market conditions, it’s not always bad for the spread to have reduced since you first received the options or since they became available to exercise.

For example, let’s assume you work for a pre-IPO company that issued ISOs, and you’ve noticed the stock’s fair market value has been fluctuating over the past year (using the 409A valuation the company provides). It is now worth seemingly less than it was a year ago. Y

ou’re hesitant to exercise at the lower fair market value, even though the cost remains the same, due to fear that the company is now worth less and may no longer be “worth” the investment. Of course, it still makes sense to consider the investment viability of the company itself. However, it could be that the fair market value has primarily been impacted by outside forces outside the company’s control.

The company may ultimately be on the path toward an IPO, but not as soon as expected. Current economic conditions could force the company to take a more conservative approach and delay potential IPO plans. If this is the case, and you still believe in the long-term investment viability of the company, you should still exercise at the lower fair market value. It will also benefit you on the tax side since the bargain element is now lower relative to where it was a year ago!

The Bottom Line

Stock options are complex, especially when considering holistic financial goals or plans. So it’s well worth the time and effort to seek professional help to maximize the benefit and avoid potential tax pitfalls.

Our best stock options advice is to calculate tax implications, determine whether to sell or hold while considering the rules of diversification, consider the timing of exercises, and not necessarily not shy away from exercises when bargain elements are lower.

If you need assistance evaluating your stock options, don’t hesitate to schedule a free consultation today!