Many companies include stock options in employee compensation packages, and if you’ve been offered stock options as part of a compensation package it’s important to understand they types of options you are being offered. This article covers some key mistakes to avoid when exercising Non-Qualified Stock Options (NSOs), termed “non-qualified” because they do not meet all of the IRS requirements to be deemed Incentive Stock Options (ISOs).
It’s important to understand the tax implications of NSOs and other considerations when deciding whether and when to exercise your options. Here or some additional things to consider when adding NSOs to your financial plan.
Don’t let the clock run out on your options
Obviously, you want to exercise your stock option when the stock is “in the money”, meaning its current value is above the grant price. For example, if you are issued options with a grant price of $50, and you exercise your option when market price $100, you realize an immediate gain. That’s the beauty of stock options.
But this is a timing game, if you are waiting for the market price to max-out, you risk letting your options expire. And once they expire, they have no value to you. Worse, if you let your options expire and the stock price is above the grant price you’ve essentially forfeiting free money.
The expiration date puts other pressures on your decision making process. If you intend to sell the stock right away, and the stock price is above the grant price, continuing to wait means you risk losing those gains. If the stock price dips before the expiration date, you are in the same boat as you would be if you had let your options expire.
Getting the timing right means having a plan and your plan needs to included your strategy for exercising and selling your options.
Avoid getting stuck with a huge tax bill
Your stock gains won’t do you a lot of good if you give them to the IRS. While you certainly don’t want to be up against the expiration date when you decide to exercise, you also want to take tax considerations into account.
For example, say your spouse is also vested in their employee stock plan. If you both exercise substantial amounts of options in the same year, the additional income could be taxed in a higher marginal tax bracket. It’s not as uncommon as you may think. After all, a rising stock market tends to lift all boats.
Staggering the exercises could be helpful. You could exercise your options at the end of the current year, then your spouse can exercise at the beginning of the following year. This splits the income between two tax years and reduces the probability of being taxed in a higher marginal tax bracket.
If your income is variable, you will want to exercise your option in a year when you anticipate less income. If you predict you will get a substantial commission or a large bonus, it might pay to wait before you exercise stock.
And remember, this isn’t typically an all or nothing proposition. If your company is in good financial health, it might make sense to exercise stock options over the course of a few years. In this respect, you might be able to make your vesting schedule work for you.
Don’t be blinded by confidence in your employer
One of the big reasons people invest in their employee stock plan is that they like the idea of having skin in the game. Chances are you anticipate being with your company for some time, and want to feel like you benefit from its continued success. And that’s great.
But things happen.
And we’re not just talking about melt-down level disasters. Even small changes in a company’s outlook can impact its share price. Another possibility is an acquisition, which can be especially complicated. The acquiring company may decide to offer cash compensation instead of shares. It may decide to offer its own stock instead of that of your current company.
The biggest issue for most investors who have access to NSOs is that it can create significant company risk, also called concentration risk, in your portfolio. How much of an issue this is depends on your overall portfolio size and how many options you are exercising and how close you are to retirement.
In general, if you hold stock in a single company that represents 10% or more of your total portfolio you’ll want to have a strategy in place account for that risk. If the value of the stock continues to rise so the amount of company risk in your portfolio.
Let’s look at an example, let’s say Company A stock makes up 10% of your total portfolio, and your portfolio is worth $3MM as you near retirement. Now, imagine the value of your investment in Company A drops 20% overnight, your portfolio is now worth $2.76MM. Assuming a 3% withdrawal rate for retirement income, that change in value means losing about $600 a month in income.
Make your NSOs work for you with a plan.
If you are participating in your employer’s stock plan it’s important that you understand how they fit in to your overall financial plan. An advisor can help you determine when to exercise your options and can help you develop a sell-strategy so that you have the best chance to maximize your NSO benefits while minimizing your company risk. You’ll also want to consult with your tax advisor to understand the potential tax implications of exercising your stock options.
The opinions voiced in this article are for general information only and are not intended to provide specific advice or recommendations for any individual.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
Stock investing involves risk including loss of principal.
CFP® Bill entered the financial industry upon graduating college, working as a bank vice president and a life insurance agent. He then established a career as a financial planner and partnered with Bill Carr to form Retirement Strategies, Inc. in 1994. Bill currently serves as an Adjunct Professor in the college of Accounting and Finance at the University of North Florida, as well as Treasurer for the Highlands Precious Gifts Preschool. He lives in Jacksonville, FL with his wife of 37...Read More