Understanding Your Employee Stock Options
Once a perk reserved for CEOs and senior managers, employee stock options are increasingly becoming a stale in compensation packages to employees of all levels.
Employee stock options allow individuals to benefit from their company’s performance and over time may represent significant value to the employee. If you have been fortunate enough to reap the rewards associated with employee stock options, now may be the time to evaluate these options in regard to your overall investment management strategy and potential tax liability. A sound strategy for exercising your employee stock options may provide significant tax savings and help you manage exposure to risk.
Exercising strategies
Selecting an appropriate exercise strategy will likely depend on many factors, including:• Your current tax bracket.• You need for income now vs. income later.• Your personal attitude toward risk• The type of employee stock options you own. Most stock options are classified as either Nonqualified Stock Options (NSOs) or Incentive Stock Options (ISOs). Because these two types of options are taxed differently, carefully consider the tax impact when choosing a strategy for exercising your options.
Several choices are available to you regarding your stock options. There are a few exercise strategies you may wish to consider.
Postpone Exercise
Sometimes it makes sense to delay the exercise of your options, particularly if you are bullish on your company’s stock. Also, this may be the only choice available to you if you are not yet vested.
Advantages• Allows you to postpone the tax liability attributable to the exercise of your employee stock options.• Allows you to take full advantage of the upside potential of your employer stock without the need to invest you own money. Disadvantages• Maintains your exposure to downside risk and market volatility. The risk could be substantial, especially if the options will expire soon and/or you have highly concentrated holdings of employer stock.• Excludes you from receiving the benefits of actually owning the company stock, such as voting rights and dividend payments.
Exercise Immediately and Sell the Underlying Stock
An exercise and sell strategy is ideal when you want to realize gains from the appreciation of your employer’s stock. This strategy is also effective in cases in which your options are about to expire, or you already have a substantial portion of your portfolio invested your employer’s stock, and you are interested in diversifying your holdings.
Advantages• Allows you to take advantage of the favorable long-term capital gain rates associated with Incentive Stock Options, provided you do not dispose of the stock until the later of one year from the date of exercise or two years from the date the option was granted.• Forces you to incur an immediate tax liability upon the exercise of your Nonqualified Stock Options, but any future increases in the market value of the stock would be taxed at long-term capital gain rates rather than ordinary income-tax rates.• Allows you to receive the benefits of owning your company’s stock, including any dividend payments and voting rights. Disadvantages• Requires that you either have the cash available to fund the exercise or that you finance the exercise of your options.• Can increase your exposure to risks associated with highly concentrated holdings of employer stock.• May create exposure to the alternative minimum tax on the exercise of an Incentive Stock Option.
Employee stock options allow individuals to benefit from their company’s performance and over time may represent significant value to the employee. If you have been fortunate enough to reap the rewards associated with employee stock options, now may be the time to evaluate these options in regard to your overall investment management strategy and potential tax liability. A sound strategy for exercising your employee stock options may provide significant tax savings and help you manage exposure to risk.
Exercising strategies
Selecting an appropriate exercise strategy will likely depend on many factors, including:• Your current tax bracket.• You need for income now vs. income later.• Your personal attitude toward risk• The type of employee stock options you own. Most stock options are classified as either Nonqualified Stock Options (NSOs) or Incentive Stock Options (ISOs). Because these two types of options are taxed differently, carefully consider the tax impact when choosing a strategy for exercising your options.
Several choices are available to you regarding your stock options. There are a few exercise strategies you may wish to consider.
Postpone Exercise
Sometimes it makes sense to delay the exercise of your options, particularly if you are bullish on your company’s stock. Also, this may be the only choice available to you if you are not yet vested.
Advantages• Allows you to postpone the tax liability attributable to the exercise of your employee stock options.• Allows you to take full advantage of the upside potential of your employer stock without the need to invest you own money. Disadvantages• Maintains your exposure to downside risk and market volatility. The risk could be substantial, especially if the options will expire soon and/or you have highly concentrated holdings of employer stock.• Excludes you from receiving the benefits of actually owning the company stock, such as voting rights and dividend payments.
Exercise Immediately and Sell the Underlying Stock
An exercise and sell strategy is ideal when you want to realize gains from the appreciation of your employer’s stock. This strategy is also effective in cases in which your options are about to expire, or you already have a substantial portion of your portfolio invested your employer’s stock, and you are interested in diversifying your holdings.
Advantages• Allows you to take advantage of the favorable long-term capital gain rates associated with Incentive Stock Options, provided you do not dispose of the stock until the later of one year from the date of exercise or two years from the date the option was granted.• Forces you to incur an immediate tax liability upon the exercise of your Nonqualified Stock Options, but any future increases in the market value of the stock would be taxed at long-term capital gain rates rather than ordinary income-tax rates.• Allows you to receive the benefits of owning your company’s stock, including any dividend payments and voting rights. Disadvantages• Requires that you either have the cash available to fund the exercise or that you finance the exercise of your options.• Can increase your exposure to risks associated with highly concentrated holdings of employer stock.• May create exposure to the alternative minimum tax on the exercise of an Incentive Stock Option.
There are other tax-cutting strategies in addition to those mentioned here. If you would like assistance in selecting tax-saving strategies that make the most sense in your situation, contact us today!