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The Go-To Guide for Maximizing Your Employee Stock Options

Most people in the workforce today don’t have the benefit of working for a company that still offers a pension.  Even if they do, every few years there is usually some type of benefit negotiation between the union and company that can drag on for months and lead to union strikes.  While the number of company’s pension plans are deteriorating, the number of employee stock options plans are on the rise.   For those lucky enough to have an employee stock option plan, it’s important to understand the inner workings of them and how to maximize their value and benefits.

Understanding Your Stock Options

Before looking at how to maximize the benefits, it’s important to understand exactly what they are.  The two most common company stock options are the Non-Qualified Stock Options (NSO) and Incentive Stock Options (ISO).  At their core, these options are a contract from your employer, giving you an option to buy a certain number of shares of a company, at a specific price, over a specified time period.  Before looking at the difference between the two and strategies for them, it’s important to understand a few key terms:

Key Terms

Grant Date

The date the company grants the options to the employee

Vesting Date

The date the employee is eligible to purchase the shares

Exercise Price

The price at which the employee is eligible to purchase shares, once options are vested

Expiration

The date after which the employee can no longer exercise the options.  Typically, no longer than 10 years from the grant date, or, 90 days from when you leave the company

 

What Are NSOs:

These are generally offered to non-executive staff, outside consultants and directors.  NSOs do not receive special tax treatment.  When NSOs are granted to employees, directors or consultants, they pay income taxes when the options are exercised and capital gains when shares are sold.  The difference between the exercise price and the fair market value of the shares are subject to ordinary income taxes in that year.

Example: A company issued an employee NSOs with an exercise price of $20 a share.  When the employee exercised the options, the value was $50 a share.  They employee would pay income tax on $30 per share.  Two years later, the employee sold the shares, which rose to $75 a share.  The employee would pay long-term capital gains rate on $25 a share.

What Are ISOs:

ISOs are almost always reserved for high-value executives.  Unlike NSOs, these types of options are given favorable tax treatment.  With ISOs, you only pay taxes when the shares are sold (in some cases, you may be subject to an AMT tax).  The taxes paid are either ordinary income or capital gains, all depending on how long the shares were held.  In order to get the preferred tax treatment, ISOs must be held for two years from the date they are granted and at least one year from the exercise date.  If this does not happen, a “disqualifying disposition” occurs and the difference in market value and exercise price is treated as ordinary income.

Example: A company issues an employee ISOs with an exercise price of $20 a share.  The employee held the ISOs for 3 years and their value was $75 a share.  Because of holding period the employee will only be subject to long-term capital gains taxes on the difference between the exercise price and the sale price.  This employee would pay capital gains tax on $55 a share. ($75 sale price minus $20 exercise price)

How to Maximize Your Employee Stock Options

Concentration of Options:

Most financial advisors will recommend no more than 10-20% in any single stock.  If a large part of your compensation is tied to stock options, this rule of thumb may be difficult to follow.  Understanding the why behind the 10-20% rule and working with an advisor to create a plan is key to your long-term wealth.  As of this publication, General Electric’s (GE) stock price is down over 60% in the last 2 years. If an employee held all of their options over the last 2 years, that part of their net worth took a large hit.  With proper planning this could have been avoided.  Most people are familiar with the concept of dollar cost averaging (DCA).  A lot of people do this monthly with their 401Ks and IRAs.  Each month a certain dollar amount is put into their accounts and invested in securities averaging the purchasing price.  The opposite can be done as well, reverse DCAing.  Instead of purchasing shares systematically, shares can be sold systematically. 

Expiration Date:

Stock options don’t last forever.  Typically, the vesting is somewhere between one and four years and the employee has 10 years to exercise the options before they expire.  Knowing when your options are “in the money” becomes extremely important.  Having a plan for each grant, and working with a financial advisor and CPA on liquidation plans for both maximizing returns and taxes is advantageous.  While it’s easy to play Monday morning quarterback after you cash in the options on potential returns/losses, if you establish a rules-based approach to your planning, you may be able to avoid a 60% GE disaster.

Other Strategies:

Max out 401K – Use the stock options to max out your company 401K.  If you are a higher income earner that does not have the ability to contribute to a Roth IRA, but your company offers a Roth 401K, this may be a smart planning technique.  Some 401Ks allow for a “mega back-door” Roth.  If these concepts are foreign to you, or you have questions on how this works, consulting with a financial advisor and CPA is recommended.

Paying off debt – This could be credit cards, cars, mortgages, student loans, etc.  Plan for this in advance.  Again, having a rules-based approach to your stock options will make strategies like this a prudent part of your overall financial plan.

Down payment – If you are saving for a new home or looking to purchase a new home, establishing a plan of when and how to execute your options tax efficiently can be valuable for adding real-estate to your net worth.

Education – Whether you are continuing your own education or looking to help a loved one advance theirs, creating a financial plan where you can systematically execute options to pay for education will lower the amount of debt needed to fund education and potentially eliminate the need for financing all together.

Tax planning – Depending on the type and quantity of options you have; you should be thinking about the tax ramifications of owning them.  While we can’t predict the future of income tax rates or capital gains tax rates, we know where they are today.  It may make sense to execute sooner rather than later.  On the flip side, it may make sense to delay.  Having a conversation with both a financial advisor and tax professional will at a minimum give you the confidence to make the right decision based on your own specific circumstances.

If you are part of the minority that work for a company that offers stock options as a form of compensation, it’s extremely important to understand not only the inner workings of what you own but what part they play in your financial life.  Be proactive in speaking with a financial advisor and tax professional to ensure you understand what you own, how they work, the tax ramifications for owning them, and how you will use this form of compensation to meet the goals specific to you and your family.

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This information has been obtained from sources deemed to be reliable but its accuracy and completeness cannot be guaranteed. Any opinions are those of the author and are not necessarily those of Raymond James. Neither Raymond James Financial Services nor any Raymond James Financial Advisor renders advice on tax, legal or mortgage issues, these matters should be discussed with the appropriate professional. Investing involves risk, investors may incur a profit or loss regardless of the strategy or strategies employed. Retaining the services of a financial professional does not ensure a favorable outcome. Links are being provided for informational purposes only. Raymond James is not affiliated with and does not endorse, authorize or sponsor any of the listed websites or their respective sponsors. Raymond James is not responsible for the content of any website or the collection or use of information regarding any website's users and/or members.

 

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Mitchell Custenborder, CFP®
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