Making decisions on how to capitalize on employee stock options may be one of the most complex financial challenges you will face. By having a well-designed strategy that incorporates your overall financial plan, risk factors, tax implications, volatility in the underlying stock, and psychological issues that may arise from that volatility, the situation can become much more manageable and less daunting. Consulting a professional with a robust process and knowledgeable oversight can turn the rollercoaster ride of ups and downs in stock fluctuations into a set it and forget it plan that helps individuals realize their financial goals. This helps transform the anxiety around how to handle this component of compensation into a proactive approach that optimizes financial needs and emotional wellbeing.
An employee stock option is a right (not obligation) to purchase company stock at a predetermined price sometime in the future. There are two main types of stock options; Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs). ISO’s have potential tax advantages versus NQSOs, but also have additional complications such as eligibility and alternative minim tax concerns. NQSO’s are simpler, and gains are taxed as ordinary income when exercised.
When an employer issues stock options, they distribute a document that details the specifics and rules around those options. It is important to thoroughly review these details to know what happens in a range of scenarios, including changes in employment (termination, voluntary leave, going to competitor, etc.) or changes in the company if it is bought or merges. Some of the key items to keep track of each stock option granted are the type of stock option (ISO or NQSO), the strike price, number of shares, vesting schedule, expiration date, grant date, the percentage in/out of the money, and estimated potential tax liability.
An important step in this process is to set goals for stock option compensation and incorporate it in an overall financial plan. This starts with the simple question of what the proceeds from the eventual sale of the stock will be used for (vacation home, education, retirement, etc.). The next step is to appropriately calculate the current and future potential value of the stock options given a reason set of outcomes. Once the options (future asset) have been linked to a goal (future liability), it is easier to associate the performance of those options and underlying employer stock with how they are helping to attain goals.
An aspect that is important to consider is the volatility in the price of the underlying stock that will significantly impact the value of stock options. Preparing for volatility and coming up with a strategy on how to manage it is critical for avoiding emotional decision making. As opposed to being a victim of large swings in price, those swings in price can be used to manage tax impact and look for opportunities to diversify single stock risk in your overall portfolio. Incorporating fundamental and technical analysis for the underlying stock can help in rational decision making and serve as a guide to exercising and selling strategies.
No one likes paying taxes, and while we can’t avoid them, we can implement strategies to reduce them. The potential tax bills from large in the money positions can be massive, and having a good estimate for this impact can help reduce the sticker shock of exercising options for tax day. It can be helpful to run scenario analysis when estimating what the potential tax risk is given possible paths of the underlying stock. Having a plan in place that factors in the tax impact can help spread the tax liability over time and provide ways to significantly reduce the overall tax bill. When dealing with ISO’s, the alternative minimum tax (AMT) is an additional complexity to consider, and can make the tax impact of a plan difficult to anticipate. While it is good practice not to allow the tax tail to wag the dog, taxes should play a part in deciding whether or not to perform a cashless exercise, what part of the year to exercise vested options, and how long to hold the stock.
One of the most difficult parts in executing a good financial plan is the psychological issues that can emerge when dealing with stock options. The complexity in stock options and uncertainty of a single stock’s performance can cause people to become paralyzed in decision making for fear of “making a mistake” or “missing out”. This is when planning really shows its value since these moves should be anticipated before they materialize to ensure that the plan is adhered to. Having a clear view of what the compensation of stock options is going to pay for, identified in the asset/liability matching in the planning step, can help stock option holders stay grounded on when goals have been reached and “earned enough”. On the other hand, recognizing the tax benefits that can be realized from exercising at low points in the stock can take some of the sting out of drops in the price that can seem painful when looked through the impact to overall net worth.
There are a lot of issues to consider when you are granted stock options, and there is no replacement for a good plan and the discipline to stick to it. Working with the right financial planning team can help alleviate some of the burden and make it so complex items are not overlooked.