For Employee Stock Options… Be Patient or Lose
Taoism tells us that mindfully strategic inaction, expressed in the concept of wu wei (which literally means “doing nothing” in Chinese), is often the most effective approach to the challenges of living. This concept always applies and is important to remember with employee stock options. Waiting as long as possible to exercise stock options (i.e. doing nothing and letting the value grow until a strategic moment) is often the soundest exercise strategy.
It’s important to note that there are two main types of stock options that both carry with them very different tax treatments.
- Nonqualified stock options (NQSOs) are the simpler and more common type.
- Incentive stock options (ISOs) are less common and more complicated in that they can offer potential tax advantages but a lot more risk.
Most of the discussion here concerns NQSOs in public companies.
1. Waiting To Exercise Is Often Best
It may seem obvious, however, it’s important to note that Stock options can be incredibly valuable and potentially life-changing. They let you purchase shares of your company’s stock at a fixed price for a specified period (typically over a term of 10 years) regardless of where it’s trading. Under nearly all grants, you have to work at the company for a specified length of time (the vesting period) before you can exercise the options. If you leave your company, the vesting stops and the term usually ends much earlier, requiring you to exercise the options soon after your leaving your job to prevent losing them. Make sure you don’t forget that if you were laid off or if you quit recently. These rules and time periods can vary according to the reason you left work (e.g. job change, disability, death, retirement). Don’t assume you’ve lost the value of them if you leave your job without getting all the facts, first.
Some companies grant stock options that employees can exercise early, allowing you to start the capital gains holding period sooner and recognize little or no income at vesting. You may want to check whether you have this type of stock option and carefully follow the rules (e.g. a Section 83(b) election), though this is not the focus of this article. (We’ll do an article later on filing an 83b election. Stay tuned).
Options Align Your Pay With Company Performance
In short, stock options let you share in the growth of your company’s value without any financial risk until you exercise the options (i.e. buy shares with cash). If your company’s stock price rises during the option term, the difference between the market price of your shares and your lower exercise price (AKA the “spread”) can make stock options incredibly valuable. You get to keep the difference (before taxes, of course) which is how people make money on stock options.
Leverage And Tax Deferral
The fixed purchase price creates the oftentimes life-changing financial “leverage” of stock options. For example, if the stock price rises by 20%, the value of your unexercised stock options grows by much more than 20%. As soon as you exercise the options and thus purchase actual shares of stock, the leverage ends. As a result, the big question that you should put a LOT of thought into is when to exercise your options. Without thought, you might forgo a lot of money.
Moreover, while cash bonuses and most other forms of compensation are taxable when you receive them, stock options defer taxes until you exercise them (aka buy the shares with cash at the fixed price in the contract). Before you exercise your options, their built-in value is subject to pre-tax growth—which can be significant.
Often no advantage exists in exercising nonqualified stock options in a public company soon after vesting, paying taxes on the spread, and then holding the shares for long-term capital gains (unless special circumstances occur, such as job termination). As long as the stock price continues to rise, (therefore increasing the difference between your fixed purchase price by using your options contract and the market price… AKA: Your gain) the leveraged value of the options grows without any tax hit, and your net after-tax proceeds will be larger.
Consider also the opportunity cost of exercising and holding NQSOs. Financial advisors often compare stock options to interest-free loans. “An option’s value is enhanced by the ability to use the capital that would otherwise be invested in the stock for some other investment,” said Blaine Thiederman MBA, CFP, and Founder of Progress Wealth Management.
For example, he explained that if your options have a 10-year term and the company’s stock price keeps rising, the options are growing tax-deferred value before you have spent any money on them. “It’s nice to be permitted to keep the gains without having to risk much money.” said Blaine. Funds that you would otherwise put into buying the company’s stock can be used for other investments, then directed later into the option exercise at the perfect moment for larger gains.
Blaine’s approach applies various ratios that consider special factors to calculate the optimal time to exercise your stock options. “There’s both art and science to exercising an options contract. Make sure you balance your risk and rewards when you do so.” said Blaine. For instance, when the stock price is much higher than the exercise price, these options with a big spread have less leverage and smaller upside from stock-price increases. These are the NQSOs that you might want to exercise and then immediately sell the shares.
2. Risk Versus Reward
As always with investing, stock options involve risks as well as rewards. If the stock price plummets below your exercise price, the value of the options vanishes. Decisions about when to exercise must therefore factor in the outlook for the company’s stock price.
To put it another way, let’s say hypothetically you paid $15/lb for a Walmart coupon book from a girl scout and intended on using your coupons to buy a steak that typically sells for $30/lb. You intend on buying 10 pounds of steak for a barbeque so, the cost makes sense. What happens if the price/pound falls to $12/lb? You wasted the cash on the coupon book and will just buy it for the market price. The risk of throwing away cash on the coupon book is the same as the risk of throwing away cash on the premium you pay for the options contract.
Another risk we have to consider is the risk of overconcentration, i.e. having too much of your net worth tied up in the stock of just one company. A single stock price can quickly fall. A diversified stock portfolio helps to mitigate that risk. When you calculate your concentration level, you should include any vested stock options you have. That can give you yet another reason to wait on exercising your options until you have a solid post-exercise plan that includes selling shares for diversification.
To lessen concentration risk and promote diversification, a strategy formulated with a financial advisor should also extend well beyond exercise, says Blaine. “Have a strategy on selling stock and where the proceeds are going to be reallocated to.” When you have a strategy, one way to document it (and provide some protection from accidental insider trading) is with a Rule 10b5-1 trading plan. He uses these for his executive clients.
Blaine also argues that taxes should not be the main driver of your decision. “While taxes are important to consider, it’s dangerous to base decisions principally on tax aspects and neglect coordination with goals and investment risk,” warned Blaine. “In other words, the tax tail shouldn’t wag the dog. If all of our decisions were focused on avoiding taxes, the best place to keep all of our cash would be in a bank account. That’s obviously not a good idea unless you’re going to spend all of it in the next 12 months.”
Nevertheless, Blaine continued, it is important to model tax scenarios for your stock options and be prepared. “To build wealth, you have to deal with tax consequences. To be smart about your tax plan, you have to have your eyes open and know what to look for.”
Blaine believes that for NQSOs you should “be prepared for your company’s tax withholding at exercise to not be sufficient to cover the tax bill.” The IRS default statutory withholding rate of 22% for supplemental income, such as the spread at option exercise or restricted stock unit (RSU) vesting, is often lower than your actual income-tax rate. If your income tax rate is well above 22%, you could be in for a major surprise come April.
While the withholding rate jumps to 37% for supplemental wage income in excess of $1 million during the calendar year, employees between those extremes will have to plan how to pay the taxes not covered by the 22% default rate. The shortfall can be paid in quarterly estimated taxes based on the amount owed, among other methods.
4. Understand The Stock Plan Documents
One of the biggest mistakes with stock options is failing to read the stock plan documents and not fully understanding the terms of the grant. Grant info needs to be organized, saved, and updated to provide ongoing guidance.
Chief among the option terms to know are the vesting provisions and what would happen upon job termination, which usually triggers a very short window for option exercise before the grant term expires. “It’s crucial to clarify equity awards’ terms for vesting and at separation of service,” stated Blaine Thiederman. “Realize they may not all be the same.”
He also noted that most option holders neglect to designate a beneficiary for vested stock options in case of death. “This is usually allowed in the plan, but often employees are unaware of that.”
Without a beneficiary, your stock options could be forced to be probated in which case, they could expire before the court permits your executor to exercise them. That could cost your loved ones an insurmountable amount of cash. Don’t make that mistake.
5. Seek Help From A Qualified Advisor
Stock options can get incredibly complicated and require us to move slowly and think through issues.
Blaine implores option holders to obtain guidance from a financial advisor and tax expert with experience in stock options, and to avoid relying on tips from co-workers. He’s seen far too many people rely explicitly on the advice of coworkers and, end up exercising too early or too late.
Exercise strategies are incredibly personal. For your own unique situation, you may need to do very different things than your colleagues.