Smart Planning for Stock Options by John NowakSubmitted by Moller Financial Services on September 14th, 2016
One common question that we receive from corporate professionals is "what should I do with my stock compensation?". By the time this question comes up, they may have owned the shares or options for years and the potential value is now worth hundreds of thousands to millions of dollars. After reviewing the details of their plan, their stock compensation is usually in the form of restricted stock units or stock options. These two forms of compensation are different from a tax, investment, and risk perspective, so it is important to focus on one plan at a time. In this post, we will explain the benefits, risks, and planning ideas to address the unique characteristics of company stock options.
Stock Option Basics
Let's start with reviewing how stock options work for most employees. First, the company issues an option grant for the employee to buy some shares of stock at the current stock price. This price is known as the exercise price. Generally, the employee must wait a minimum number of years to exercise the option to buy these shares. This waiting period is known as vesting. After an option grant vests, the employee can exercise their option to buy the shares at the exercise price. If the current price is greater than the exercise price, the employee can make a nice profit from exercising the options and selling the shares. The employee's option to buy the shares usually expires ten years after the date of the grant or sooner, so there is a deadline for taking action. Below is a general timeline for how this scenario might work.
- 8/15/2011: Company grants an employee the option to buy 1,000 shares at $60 per share with a three-year vesting period.
- 8/15/2012: The company stock price has grown to $65, but nothing changes because the options have not vested.
- 8/15/2014: Stock price is $75 per share. The employee's options vest and are now worth $15,000 (1,000 shares times $15 per share profit; profit equals current price minus exercise price).
- 8/15/2016: Stock price is $100 per share. The employee decides to exercise the option to buy 1,000 shares at $60 per share (exercise price), well ahead of the expiration date of 8/15/2021. The employee immediately sells the shares at $100 (today's price) for a profit of $40,000.
For nonqualified stock options, the income is realized and tax must be paid when the option is exercised. The amount of income is the gain between the current price and exercise price. Whether the employee holds onto the stock or immediately sells it, the income tax treatment is the same. The key for determining income is the employee's decision to exercise the option. This income is regarded as employee compensation for tax purposes, like a cash bonus.
For incentive stock options, the gain may qualify for a lower long-term capital gain tax rate if the employee holds the shares for at least one year after exercising the options. However, the employee will report this gain as income for alternative minimum tax (AMT) in the current year if the options are exercised, but not sold. When the shares are sold after one year, the long-term gain is reported for taxes and there is an AMT deduction for the previously reported amount of income. Incentive stock options are even more complex than their nonqualified sibling and need additional planning considerations for taxes and risk.
Stock Option Benefits
When an employee receives stock options, their financial reward is many times greater than the growth of the company's stock price. Using the same example above, let's examine the change in the value of the option compared to the change in stock price.
The difference between stock price growth and option value growth is staggering and might make you wonder if some companies are incentivized to quickly drive up the stock price rather than invest for longer-term growth for the company. Regardless of the incentives, one relationship is clear. The closer the current stock price is to the exercise price, the larger the percentage gain or loss for the option. If the stock goes up, GREAT. But if the stock price goes down...
Stock Option Risks
To show the downside risk of employee stock options, let's continue the example we've been using.
|8/15/2017||$80 (-20%)||$60||$20,000 (-50%)|
|8/15/2018||$70 (-12%)||$60||$10,000 (-50%)|
Wow! So when an employee stock option already has value (called "in-the-money”), the option value decline is much greater than the price decline of the stock price. The value of the option is much more sensitive than the company stock price IN BOTH DIRECTIONS.
In addition to stock price being a major risk to employees, time is also a factor. Employee stock options have an expiration date. Like the food in your refrigerator, if the option is not used by this date it is tossed. We have heard many many people say "I will sell the stock that I have once it gets back to $XX." (This is a behavior bias most investors have called anchoring.) Perhaps you have said these words during your investing experience. The problem with stock options is there may not be time for the price to "get back". A stock price and option expiration date do not communicate. The price can go down and the option value may not have a chance to recover.
Stock Option Planning Ideas
Employee stock options are a multi-dimensional planning responsibility for a client that may include taxes, portfolio concentration in one stock, stock price sensitivity, and personal timelines such as paying for college, retirement, or potentially changing employers. For each situation, it is important to understand each of these factors when it comes to developing a plan and following through. We consider the following as we begin developing a strategy to manage employee stock options:
- Determine each option's sensitivity to the change in stock price, before and after taxes.
- Compare the option's time to recover from a price decline to the option's expiration date. Create a scenario of exercising the option three years before expiration to avoid a stock price decline too close to expiration.
- Consider the timing of other employee stock compensation such as restricted stock units (RSUs) for tax purposes.
- Consider the overall financial concentration to the company including salary, bonus, stock options, RSUs, employee stock purchase plan, etc.
- Determine when and how other financial commitments will be funded such as college, a second home, and retirement.
The final key with employee stock options is to understand they are "options". Far too many people feel handcuffed and confused by the terminology, taxes, or how they work. As a result, this valuable asset is often ignored or not managed in a complementary strategy for the overall plan. By understanding the characteristics, risks, and benefits, you can reclaim these stock options as manageable pieces for your comprehensive financial plan.