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.
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. You’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!