Stock Options Basics.
How to minimize you taxes and maximize your benefits.
If you have employee stock options (ESO) but have no idea how to handle them, don’t feel bad because even well trained professionals can find them a challenge. But if they comprise a sizable portion of your net worth, you’ll do well to put in the time and energy learning to put them to their best use.
By David Rae Certified Financial Planner™, Accredited Investment Fiduciary™
How do Stock Options Work?
Many people find anything remotely financial confusing and stressful. Well guess what? In many cases, stock options are even worse. Many people have two, three or sometime even four or five different “stock options plans” listed on one statement from one company stock. They all have different vesting rules, values, taxability and so on. Yikes! Consequently, only rarely do I speak with someone who completely understands their stock options and rarer still, that they are taking full advantage of their money potential.
For some people, they just happen to own some shares that are just sitting in some account out there, that they have no idea what to do with. For others, their shares literally make up 100% of their long-term savings. (It’s good problem to have when the numbers get large, and one that can be easily rectified with the proper financial guidance from a Fiduciary Financial Planner.)
When managed properly, employee stock options (ESO) plans can an extremely lucrative perk of working for a thriving (or soon-to-be) company. But if not handled properly, they can turn into a tax-planning nightmare, landing you in the purgatory of Alternative Minimum Tax Problems (AMT).
If you have stock options be the unicorn and have a financial plan to maximize their value for your long-term goals, while being strategic to minimize their taxation.
Employee stock options basics defined
In simplest terms an employee stock option is a contract from your employer to allow you to buy the company stock at a specified price over some specific window of time. The two most common types of stock options are:
- NON-QUALIFIED STOCK OPTIONS (NSO)
- INCENTIVE STOCK OPTIONS (ISO)
There are two main ways that these plans differ. First, NSO’s are generally offered to non-executive staff, outside consultants and directors and do not receive special tax treatment. On the flip side, ISO’s are almost always reserved for high value executive type employees (hence the incentive stock options from Silicon Valley companies Space X, Sony or even Boeing for a few examples.) In typical rich-get-richer style, the options that go the big earner ISO’s are given favorable tax treatment assuming they meet specific rules descried by the IRS. (More on the tax treatment later, but if you have an ISO plan and it doesn’t meet the IRS guidelines, well somebody should look into fixing that problem and pronto!)
Confused yet? It’s no wonder; stock option plans are complex. There are so many variables, and plans must follow both the employer agreement and IRS revenue rules. You may also have things like stock purchase plans, restricted stock options and other type of shares but more on these at another time.
Essential stock options basics vocabulary
- GRANT DATE: Most of the time you are not granted full ownership of actual stock right off the bat. The grant date is the initial date that the options are granted to you.
- VESTING: Vesting is you actually have full control of the options. From there you will normally be subject to a vesting schedule. The vesting schedule will begin the day the options are granted, and will list the specific time when you will able to exercise your options and how many shares can be exercised.This whole process is about as much fun as running on a treadmill in a wetsuit. To give an example, if you are lucky enough to be granted 10,000 shares on the grant date, but 20% vest each year, you would be able to sell 2000 shares one year from the grant date. The following year another 2000 shares would become available and so on.
- EXPIRATION DATE: At some point the options will expire if you do nothing with them. This day is the expiration date. Once the expiration date has passed the employer is no longer on the hook to honor the stock options agreement. So make sure you know your expiration dates, and don’t miss them.
- EXERCISE: There is a specific price listed when an employee stock option is granted known as the exercise price, this is what you would pay to buy your options. The gain from your purchase is determined by the gap between the value of the stock at the time of exercise and the exercise price. This gap is known as the “Bargain Element” which is considered “compensation” and taxed at ordinary income tax rates.
Stock options and taxes
If you want to maximize the value of your options and help minimize the tax bill, you will need to follow a specific set of rules from the IRS. Ultimately taxation will depend on timing and the type of ESO plan you owned.
Non-qualified stock options (NSO) taxation
- The granting of NSO stock options is not a taxable event.
- The taxation begins once you have exercised your stock options. The bargain element in non-qualified stock options is considered compensation and is taxed at ordinary income tax rates.
- There are essentially two taxable events with NSO plans:
- Exercise of the options and eventually selling the stocks. If you choose to sell the exercised stocks in the first year the transaction will be reported as a short-term capital gain (or loss).
- Short-term capital gains that are taxed at ordinary income tax rates. If you hold the shares beyond one year the gains will be reported as long-term capital gains. For most people reading this, long term capital gains rates are markedly lower than their ordinary income tax rates.
Incentive Stock Options (ISO) special tax treatment
- Granting of ISO stock options is not a taxable event.
- Unlike NSO plans, exercise of Incentive Stock options does not trigger a taxable event. But beware that the bargain element of ISO plans may trigger the Alternative Minimum Tax (AMT)
- For ISO plans, the first taxable event occurs at the sale of shares. If sold immediately, the bargain element is treated as ordinary income (with the higher tax rates that come with it).
- To achieve long-term capital gains rates you should make sure to hold for 12 months after being exercised and not sold within two years of the original stock grant date.
At this point, you have every right to run screaming for the exits. But bear with me . . .
Stock Options Basics and your Financial Plan
When planning to maximize the benefits of your options plans there are several points to consider; taxation, stock values, and overall investment allocation. Generally you wouldn’t want more than say 5% of your net worth in single stock. With substantial stock options you may need to push that higher, still with a goal of no more than 20% of your net worth in a single stock. Consult your Fiduciary Financial Planner to develop a course of action to make sure you follow the tax rules above while moving towards a more appropriate overall financial portfolio for your specific goals, time frames and risk tolerance. You may love your company stock and company even more, but there is just too much risk to have all your money in any one stock, let alone stock in the company where you derive your income.
You may read this and go “OMG 99% of my net worth is in my company stock options!” This is NOT your cue to run out and sell off large chunks without considering the tax consequences. I usually develop a plan to help people sell off options over time, as tax efficiently as possible with the dollar cost essentially averaging out of the stock over time. This stock options sell off plan has their overall financial picture and goals in mind.
Bottom line for you Stock Options Basics and your financial plan
Stock options appear to be growing in popularity in recent years, certainly in tech and media circles. We’ve all heard stories of tech workers slaving away for years, and with that in mind they should make every effort to get the most value from the stock options they have already accrued and may accrue in the future. From the company standpoint it’s a great way to motivate employee–if the company does well, it’s a no-brainer to think the stock would do well too (not always the case, but you get the point).
Take heart, I can’t remember a time when a new client walked in and really understood much about their own stock options. Generally the conversation is more like, “I have some options and here’s the statement to review.” Or, they have heard from a co-worker how they got killed with taxes from good ol’ Uncle Sam when they “got options”. Whatever your reason, it’s a fine time to talk to a Fiduciary Financial Planner to subtract some of the emotion out of the conversation, make smarter decisions for your financial future and put a solid strategic plan into place when it comes to timing.
Stealing a lyric from Les Mis’ “One Day More”, this can mean the difference between short-term capital gains and long-term capital gains. Indeed, one day more could mean thousands of dollars in tax savings.
Live for Today but Plan for Tomorrow (it’ll be here sooner than you think.)
DAVID RAE, CFP®, AIF® is a Los Angeles-based Certified Financial Planner™ with DRM Wealth Management, a regular contributor to Advocate Magazine, Huffington Post, Investopedia not to mention numerous TV appearances for on CBS, ABC, NBC, KTLA, KCAL and even Fox and Friends. He helps smart people across the USA get on track for their financial goals. For more information visit his website at www.davidraefp.com
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The opinions voiced in this article are for general information only.