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Only 16 percent of companies still offer traditional pensions.  Every few years negotiations take place between these companies and the unions over benefits. The negotiations can drag on for months and can lead to strikes.  While the number of pension plans are deteriorating, the number of employee stock options plans are on the rise. For those with employee stock option plans, it’s important to understand how to maximize your employee stock options and the key terms associated with them.

Understanding Your Stock Options

Before looking at ways to maximize the benefits, let’s cover the basics.  In many cases, Non-Qualified Stock Options (NSO) and Incentive Stock Options (ISO) are additional forms of compensation. The table below outlines the key terms.

What are NSOs

NSOs are generally offered to non-executive staff, outside consultants, and directors.  The downside to NSOs is they do not receive special tax treatment.  Income taxes are paid when the options are exercised and capital gain taxes are realized when you sell the shares.

Example: A company issued an employee NSOs with an exercise price of $20 a share.  When the employee exercised the options, their value was $50 a share.  The employee would pay income tax on $30 per share.  Two years later, the employee sold the shares, which rose to $75 a share.  The employee would pay a long-term capital gains rate on $25 a share.

What are ISOs

ISOs are almost always reserved for high-value executives.  Unlike NSOs, ISOs receive favorable tax treatment. Taxes are only realized when the options are sold. As a result, the holding period will determine if they are taxed as ordinary income or capital gains. 

Example: A company issues an employee ISOs with an exercise price of $20 a share.  The employee held the ISOs for three years. After the three-year holding period, their value was $75 a share.  Because of the holding period, the employee will only be subject to long-term capital gains taxes. The LT capital gain is on the difference between the exercise price and the sale price.  This employee would pay capital gains tax on $55 a share. ($75 sale price minus $20 exercise price)

Pitfalls to Avoid

Over Concentration

Most financial advisors will recommend no more than 10-20% in a single stock.  If a large part of your compensation is tied to stock options, this rule of thumb may be difficult to follow. Overconcentration can ruin an individual’s long term goals. Look no further than General Electric (GE). As of this publication, GE’s stock price is down over 60% in the last 24 months. Single stock risk is a real concern for employees with large grants. By systematically reducing your overall concentration you can diversify away some of the risks.

Missing the Dates

Stock options don’t last forever.  Typically, the vesting schedule is set to somewhere between one and four years. The employee will generally have 10 years to exercise the options before they expire.  It’s likely that you will have multiple grants to track and knowing when your options are “in the money” becomes extremely important.  Working with a financial advisor and tax professional can be advantageous in navigating these complexities. These two professionals can assist you by keeping track of each grant and the key dates to each. They can also provide guidance in creating a plan to maximize returns while being as tax efficient as possible during liquidation events. 

Maximize Your Stock Options

Max out 401K

Use your stock options to max out your 401K.  If your income does not allow for Roth IRA contributions, determine if you have a Roth 401k available. Some 401Ks allow for a “mega backdoor” Roth.  If these concepts are foreign to you, or you have questions on how this works, have a conversation with your financial planner.

Paying off Debt

This could be credit cards, cars, mortgages, student loans, etc.  Plan for this in advance.  You will have a few years between each grant and vest to create a plan before having to execute it. Having a rules-based approach to your stock options will make strategies like this a winning proposition.

Real Estate

Are you saving for a new home or looking to purchase an investment property? Establishing a plan for when and how to execute your options, tax efficiently can be valuable. By taking some risk out of your company stock, and the stock market, you can increase your net-worth in an asset with less correlation to the stock market.

Education

Whether you are furthering your own education or looking to help a loved one advance theirs, using your options can be a good strategy. Creating a plan to systematically exercise options to pay for education will lower the amount of debt needed to fund education and potentially eliminate the need for financing altogether.

Tax Planning

Understand the tax ramifications of owning options should be a priority. While we can’t predict future income or capital gain tax rates, we know where they are today.  Depending upon your tax bracket, executing sooner than later may be beneficial.  On the flip side, it may make sense to delay.  Either way, having a conversation with a financial advisor and tax professional should give you the confidence to make the right decision based on your own specific circumstances.

All said, be proactive. Reach out to a financial planner and tax professional for help. Create a plan of attack for each grant you receive. Determine how you will exercise the options and the tax ramifications of doing so. A little planning will go a long way toward achieving your goals.