Stock options can be one of the secrets to building wealth in a corporate environment. It’s more common today to see restricted stock grants offered to employees. But if you’re lucky enough to have stock options, you need to understand the value of what you’ve been given.

Key Terminology

When you receive a grant of stock options, you have been given the chance to buy company stock at a future date for today’s price. Usually the options vest over a period of time. Just the terminology used when describing stock options can be confusing. Let’s review what you need to know:

Grant date:
The date the company puts the stock option plan in place

Exercise price:
What you have to pay when you exercise the option

Fair market value (FMV):
The price of the stock on the day you exercise your option

Bargain element:
The difference between the fair market value at exercise and the exercise price

Vesting dates:
Dates when you are allowed to exercise your options

Expiration date:
The last day of the stock option plan. If you haven’t exercised your options by the end of the plan, you get nothing.

Alternative minimum tax (AMT):
A separate tax imposed on certain transactions. Incentive stock option (ISO) exercises trigger AMT, while non-qualified option (NSO) exercises do not. With proper planning, you may be able to minimize or avoid paying AMT tax on ISO exercises.

Incentive Stock Options (ISOs):
A type of stock option plan that treats exercise of shares as an AMT preference item. The difference between the exercise price and the sales price is taxed at capital gains rates. When the options are granted, there is no tax effect.

  • When you exercise the shares, you pay the exercise price per share. Although no ordinary income tax is due, the bargain element is a preference item for AMT. That means you should do tax planning before you exercise an ISO.
  • If you hold these shares for at least one year (and two years past the grant date), then when you sell you will owe capital gains tax on any appreciation above your basis in the stock (the exercise price).
  • If you don’t meet the holding requirements above, then you create a “disqualifying disposition.” Essentially this means that your gain plus any appreciation is taxed at ordinary income rates instead of capital gains rates.Let’s look at an example:
At exercise:
Fair Market Value: $100
Exercise price $20
Taxable ordinary income $0
Potential AMT Income $80
At sale (more than one year later):
Fair Market Value: $150
Exercise price $20
Taxable capital gain $130

Non-qualified Stock Options (NSOs):
A type of stock option plan that taxes transactions at ordinary income tax rates. There is no tax due when the shares are granted.

  • When you exercise the shares, you pay the exercise price. Ordinary income tax is due on the bargain element of the option.
  • When you sell the shares, the appreciation (or depreciation) from the exercise date is taxed at capital-gains rates. If you hold the shares after exercise for at least one year, you pay long-term capital-gains rates. If you hold them less than one year, you pay ordinary income-tax rates.Let’s look at an example:
At exercise:
Fair Market Value: $100
Exercise price $20
Taxable ordinary income $0
Potential AMT Income $80
At sale (more than one year later):
Fair Market Value: $150
Exercise price $20
Taxable capital gain $130

Stock Option Strategies

Now that you understand the basic terminology, let’s talk about strategy. No matter what type of option you own (ISO or NSO), you can do three things:

  1. Continue to hold the options
  2. Exercise the options and hold the stock
  3. Exercise the options and sell the stock (cashless exercise)

You also need to understand how to value your options. This is the calculation we use to find the value:

(Fair market value of the stock minus exercise price) times number of shares

If the fair market value of the stock is more than the exercise price, your options are “in the money.” If not, you’re “under water.”

You should make sure you understand your company’s policies should you leave the company or if you die. Some companies allow you to transfer the ownership of the options to a trust.

Time Value
What makes stock options potentially more valuable is the leverage factor over time. That bargain element can grow substantially over time because the exercise price will usually stay the same (I have seen some exercise prices that “float”) and hopefully the value of the stock will go up.

Advisors can use a type of Black-Scholes calculation to find the time value for each option. This formula considers the basic valuation of the stock and factors in the volatility of the stock, the time until expiration, the dividend yield and the risk-free rate of return. We can also make a few general assumptions:

  • As the expiration date gets nearer, the time value goes down.
  • The more “in the money” the options are, the less important time value becomes.
  • If you have a very volatile stock price, time value becomes more important.
  • The higher the risk-free rate, the greater the time value.

If you have a low time value, think about exercising the stock. If the time value is high, hold the option.

Diversification
Tying up more than 10% in one stock is risky. If you have stock options, restricted stock, outright stock and so forth, you are probably over-concentrated. You need to address that, although many times you can’t in your prime working years. Lots of companies have holding requirements for top executives. But as you get closer to retirement, you need to start working on divesting shares so that your risk decreases. It may make sense to give up some upside to build a more secure nest egg of diversified holdings.

Decision Criteria
Like most types of financial planning, making decisions about stock options means weighing a number of competing factors and prioritizing based on your objectives. Think about the following:

  • Taxes: A major part of stock option planning is factoring in taxes, especially with ISOs. This usually means a multi-year approach so that you spread the tax out over a number of years. If you are thinking about doing other types of tax planning, such as Roth IRA conversions, you need to think about what cash flows will be taxed at capital gains rates, which at ordinary income rates and when those taxes will be due.
  • Cash Flow: Your option strategy should fit into a broader financial plan that considers your needs over time–children’s education, retirement goals or major purchases. You can create a strategy to pull targeted amounts of cash out each year, assuming the stock price cooperates. And if you plan to exercise and hold, you’ll need to make sure you have the cash to purchase the options.
  • Stock Price: Your stock options can be worthless if the stock price goes nowhere. But they can also be the greatest form of reward if the company does well. As you create your strategy, think about where the stock price is now and where you think it may be over time.
  • Option Valuation: Be sure you understand the time value of your options and use that in your strategic plan.
  • Over-concentration: Have a plan to reduce your holdings in company stock, especially as you approach retirement.

Applying What You’ve Learned

1. You should defer exercising your stock options if:

  • The stock is doing well and you want to let it appreciate.
  • You don’t have the cash to exercise and hold the shares.
  • You want to postpone tax liabilities.
  • You want to limit losses in case the stock goes down.

2. You will want to exercise your options and hold the shares if:

  • Your stock options are about to expire and you think the shares will continue to appreciate.
  • Dividends on the stock are high and can offset part or all of the cost of borrowing to exercise your options.
  • Your company requires you to hold a certain percentage of company stock.
  • You want to get the clock ticking on the one-year holding period to qualify for capital-gains treatment on sale of shares.

3. You should exercise your options and sell the shares if:

  • You need the money.
  • You don’t have the cash to exercise and hold the shares.
  • You want more diversification in your portfolio.
  • Your stock options are about to expire and you need the cash.
  • You think the stock price may go down.

The strategy you choose will determine what tax rates you will pay and when you will have access to the after-tax money. You will also need to think about whether the money to exercise your options will come from your own pocket or from a loan.

Your Stock-Option Checklist

1. Find out what type of options you own. Are they nonqualified or incentive?

  • When you received your grant, you probably also received documentation that told you which kind you have.
  • If you can’t find that information, call your company’s human-resources department.

2. Figure out what your stock options are worth. Subtract the exercise price from the fair market value and then multiply by the number of shares you own.

  • If the fair market value is greater than the exercise price, your options are “in the money.”
  • If the fair market value is less than the exercise price, your options are “underwater,” or “out of the money.”

3. Know key dates for your options, including:

  • Grant date.
  • Vesting dates.
  • Exercise date.
  • Expiration date.

4. Examine the tax consequences of your type of stock option, both at exercise and at sale.

  • At exercise, nonqualified options trigger ordinary income tax on the bargain element. Incentive stock options aren’t taxed for ordinary income tax, but they may trigger AMT.
  • At sale, nonqualified options held at least one year after exercise will trigger capital-gains tax on the appreciation above the fair market value at exercise. Incentive options held at least one year from exercise will trigger capital-gains tax on everything above the exercise price paid.

5. Do tax projections before exercising incentive stock options to determine how many options to exercise without triggering AMT. This is also important if you’re also considering Roth IRA conversions or taking capital gains from investments as part of your overall strategy.

6. Decide how you will pay when you exercise your options.

  • Pay cash.
  • Do a cashless exercise, in which your broker loans you the money to buy shares and simultaneously sells the shares. You get the net proceeds from the transaction.

7. Know what happens to your options if you leave the company, at either your choice or your employer’s choice.

8. Know what happens to your options if you die. Is there a time period during which your heirs can exercise your options?

Because stock options are one of the key components of compensation today, it is important to understand how to integrate them into your overall financial strategy. After all, you may be able to use your stock options to finance your kids’ college education, retire early or buy that Tesla you’ve been eyeing.

Disclosures
The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.