If you work for a company whose share price is on an uptrend, and whose management favors incenting and rewarding employees with stock options, you might be in an enviable position. Although the use of options as a factor in compensation packages has become more widespread, there are still many people who are unaware of their rights and responsibilities, and the potential financial impact of options.
The following are some considerations to help you incorporate options into your financial planning. First, you must do your personal homework in setting some goals for use of the options. Will they be used for meeting current economic needs, such as a new addition to your home, or do you consider them as a part of your long-term financial plan, which includes funding an early retirement or paying for a child’s education? Next, you will want to determine a strategy for utilizing the options. For example, you may want to stagger the exercises and subsequent sales over a period of years to help lessen the impact of taxes. Deciding randomly, at the beginning or end of each year, to exercise or sell during the year may generate unnecessary taxes or reduce opportunities for additional gains. A traditional stock option is good for up to ten years in the future. If the prospects for your company are strong, you may be better off waiting to exercise options. You should, however, keep track of expiration dates, so that options do not expire unexercised.
Read the option plan and your grant agreement carefully. These documents inform you of your rights if you are fired, resign, go to work for a competitor, retire, become disabled, or die. Many plans allow an employee 90 to 180 days to exercise vested options after retirement and disability. Usually, options are lost if an employee works for a direct competitor. Your spouse or partner, financial professional, and legal professional should know the details of these documents so they can be prepared to act on them, should the need arise.
The option documents should also tell you if you have incentive stock options (ISOs) or nonqualified stock options (NQSOs). Each presents a different impact on your tax picture. With NQSOs, you will owe taxes at your ordinary income rate on the spread between the option exercise price and the market price, whether or not you immediately sell the share. However, with ISOs, if you hold the shares for a year or more, you will be subject to the alternative minimum tax (AMT). The AMT rules require you to include the spread on exercise of ISOs in a calculation of alternative income that is used to recompute your tax.
Some companies are granting options that are immediately exercisable, but have resale restrictions that lapse over time. In this case, you need cash to exercise and hold the shares after exercise. This option may be attractive in private companies that contemplate going public. Under these circumstances, an employee should file a Section 83(b) form with the Internal Revenue Service (IRS) within 30 days of exercise. At that time, an option holder pays a tax on the spread between the option price and the market price. When the stock is sold, the gains will be taxed at long-term capital gains rates.
If you have accumulated a significant number of options, and they represent more than 25% of your net worth, diversification may be more important than waiting to exercise your options. Some companies consider stock ownership an implicit requirement for advancement. In this case, you must exercise some of your options and purchase shares. As always, it is a good idea to consult a financial advisor, accountant or legal professional for specific advice concerning your options. Make sure this professional is someone who works with stock options and is familiar with the laws relating to them.