This tax season we received a lot of questions about employee stock options. If you are fortunate enough to have earned stock options from your employer, you have a great opportunity to enhance your financial position. However, managing stock options can be one of the more complex financial challenges you will face. One slight miscalculation or misunderstanding can turn your reward into a financial nightmare. Although managing stock options is highly individualized based on your financial, tax and employment circumstances, we offer these guidelines as framework for a better understanding of how they work and what to watch out for. Keep in mind these guidelines are only intended to give you the basics.
Know Which Type of Stock Option You Have
There are two broad categories of stock options: incentive stock options and non-qualified stock options. The difference has to do with their tax treatment.
- Incentive stock options (ISOs) are typically given to employees as a form of compensation. Employees are granted the option to buy the company’s stock at a low price when they exercise the option. There is no tax consequence until the stock is sold (except in cases of the AMT). If the employee waits at least a year to sell the stock, the proceeds are taxed at the favorable capital gains tax rate.
- Non-qualified stock options (NSOs) are also used as a way to compensate employees. This type of option does not receive capital gains treatment and the compensation is taxed as ordinary income upon exercise. The amount included as compensation is the difference between the amount the employee paid for the stock and its fair market value. (For related reading, see: Getting the Most out of Stock Options.)
Know the Value of Your Stock Options in Your Financial Plan
The biggest decisions you have to make are when to exercise your options and when to sell the stock. Knowing the options’ value and how the stock fits into your overall plan can bring clarity to those big decisions. Set specific goals for how you want to use the proceeds. That will help you determine how much stock to sell and when. You will also need to do some tax planning to spread the stock sales as needed to minimize taxes. By incorporating your options into your financial plan, you will be able to better track expiration dates.
Know How Long to Wait to Exercise
The ideal scenario for holding stock options is your company is doing very well and its outlook is good. Under those circumstances you want to hold on to your options as long as you can. As your company’s stock value increases, the value of your options increases without you having to make a cash investment. However, if it reaches the point when the value of your stock options represents much more than 25% of your net worth, you should consider selling some stock for the sake of diversification. We all remember Enron. (For related reading, see: Avoid Premature Exercise on Employee Stock Options.)
Know the Rules of Your Options
Option plans vary widely when it comes to specific exercise and vesting rules. You need to know your rights if you leave your employer before you exercise. Some plans require you to exercise your vested options within 90 days of termination. Some plans will also rescind options if you leave to work for a competitor. Some companies now offer options that are immediately exercisable but have resale restrictions with varying timeframes. This could be a good strategy if your company is in a pre-IPO stage and you expect the stock price to run up at the time of the IPO.
Know About the AMT
If you have ISOs, you could be subject to the dreaded alternative minimum tax (AMT) if you hold your shares for a year to qualify for capital gains treatment. The AMT calculation includes the spread on the exercise of your ISO even if you haven’t sold your shares. If it triggers the AMT, you would have to add back a number of standard deductions and then pay your tax at a higher rate. It can get very messy and, if you’re not prepared for it, you could be forced to sell shares at the wrong time to cover the higher taxes. (For related reading, see: How to Cut Your Alternative Minimum Tax.)
In general, you should know exactly where your income is in relation to the tax brackets. If a stock option gain pushes you into a higher tax bracket, you may want to consider exercising a small number of options and delaying the rest into future tax years.
Know Where to Turn for Advice
Your company's HR department should be able to provide some educational materials on managing stock options. However, there’s a key difference in understanding how stock options work and understanding how they work in your particular situation. There are too many variables to leave it to a generic understanding. Have a financial advisor look at your specific financial needs, objectives and tax situation to help you optimize the value of your options in your overall financial plan.
(For more from this author, see: 10 Ways to Cut Spending Before Retirement.)