What to Know Before Exercising Stock Options

Companies are always trying to attract talented workers by granting options to either purchase company stock at a discounted price, which the employee can then sell for (hopefully) at a higher price or as a simple 'perk' for being employed. Understanding the difference is paramount in lowering your tax burden. NON-QUALIFIED and INCENTIVE STOCK OPTIONS ("Qualified" Stock Options) are the two most common types of stock options employers arrange for their employees.

Generally, you will owe no tax when Non-Qualified options are granted. You are required to pay ordinary income tax on the difference, or "Spread," between the Grant Price (the price the company sold you the stock) and the stock's current market value (set at the exchange close on the day of execution) when You purchase ("exercise") the shares. Companies get to deduct the "Spread" as a compensation expense. Non-qualified options can be granted at a discount to the stock's market value. They also are "transferable" to children and to charities, provided your company permits it.

Incentive Stock Options (aka "Qualified" Stock Options), qualify to receive a special tax treatment. Your income tax is deferred until you sell the stock so, there is no income tax due at when the options are granted or exercised.

At that point, the entire option gain (the initial spread at exercise plus any consequential assessment) is taxed at long-term capital gains rates, provided you sell at least two years after the option is granted and at least one year after you exercise. If you do not meet the holding-period requirements, the sale is governed a "disqualifying disposition," and you are taxed as if you had held non-qualified options. The spread at exercise is taxed as ordinary income, and only the consequential assessment is taxed as capital gain.

Unlike non-qualified options, Incentive Stock Options may not be granted at a discount to the stock's market value, and they are not transferable, other than by a distribution from a will or trust from the death of the stock options holder. IRS caps the annual amount of Incentive Stock Options exercised in one year to $ 100,000. The spread at exercise is considered a "preference item" for purposes of calculating alternative minimum tax (AMT), increasing the taxable income for AMT purposes (Bargain Element). A disqualifying disposition can help avoid this tax.

Choosing the right moment to exercise is not as easy as it looks. Improperly exercising stock options can cause real financial headaches, particularly when it comes to paying taxes on your profits. Even if you keep the stock you purchased, you may still have to pay taxes. Many employees are not aware of a strategy for exercising their stock options, which could produce large tax bills when April 15th rolls around.

For many recipients of stock options, employees will wait until the stock price increases so they can use the "windfall" for a big vacation or major update to their house. By waiting, employees may lose their control of when to sell because their options expire and they are forced to sell before they lose all their value. Employees need a disciplined strategy when evaluating stock options, in order to make the smartest possible financial decisions.

Here are 6 Key Questions to Ask for a Successful Financial Outcome.

Timing – When are the Stock Option Vested?

A typical vesting schedule is over four years, with one-quarter of shares vesting after each year. It's important to understand when you will actually acquire the shares. Once the shares are vested, you can exercise and sell that portion of the stock options.

Taxes – What is the Proposed Overall Tax Bill?

By exercising and selling your options assures the stock is taxed at an elevated rate and it will directly affect other sources of income, high tide raises all ships. One of the best pieces of advice is to project the overall tax burden from exercising and selling the options. Timing is everything, waiting a year before selling should qualify the option into capital gains tax rates instead of ordinary income tax rates. This decision involves risk due if the stock price falls after exercise to where the stock options become worthless, the exercise may still be subject to the Alternative Minimum Tax.

Asset Allocation – How much is too much?

The "Concentration" Risk has to be considered so that the success of a portfolio is not dependent on one fluctuating stock price. It is important to have a disciplined financial plan that incorporates an exit strategy that will rebalance if any one stock appreciates over a certain percentage of the overall portfolio (say 10%). We have seen plenty of retirement plans going to zero during the "Tech Bubble" in the early 2000's and just 8 years later.

Measuring Stick – What are the Quantitative, Qualitative and Technical Attributes of the Company?

Many clients love their company they work for and who can blame them? Working here in the Motor City we are constantly helping executives from the Big Three as well as Automotive Suppliers and they all come in with the same mindset that their companies have been very good to them. They have built a nice living, putting children through college and saving up for a pretty nice retirement. They are right, but it still smart to check the vitals on any organization in any industry, especially when everything is becoming more and more global. There are a lot more moving parts in investigating fundamentals of any company. Simply understanding the Average Deviation of the company's stock can help determine the trend and volatility to pinpoint the overall risk a single stock can imposes on the overall performance of a portfolio.

Dollar Cost Averaging – Is there a Stock Purchase Plan?

Employees generally have access to an employee stock purchase plan (ESPP). By understanding the vested schedule and options that are available, an employee can establish target prices to exercise and sell their respective options.

DILUTE and STOCK BUY-BACK – What is the Company News?

I am not talking insider trading, but keep an eye for company news regarding its stock, especially if they plan to release more stock into the market or what the trends have been lately are stock buy-backs. This is the case where less is better, normally.

A third-party professional trained and focused in this area can help tremendously in putting together a plan that will reduce costs, taxes and risk while improving the overall effectiveness of having a stock option plan in the first place.

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