Strategies for Optimizing Employee Stock Options

Annrose Isaac CPA, CFP®, MBA
Annrose Isaac CPA, CFP®, MBA
optimizing employee benefits

In recent years, stock options have begun to regain their popularity in executive compensation packages, after falling out of favor during the dot-com bust. Their recent resurgence means there are also growing numbers of executives making poor choices, often because they lack good advice or because they have unwarranted optimism about their companies’ stock prices. Making good decisions and maximizing the value of your stock options starts with understanding what you have. Then, you can begin to develop a strategy that optimizes their value by incorporating tax consequences, your personal risk appetite, the company’s outlook, and more.

Stock Options: Understanding What You Have

Companies use stock options as incentive compensation to both reward and retain valued employees. Though this may vary, it’s typical for 20-25% of an employee’s stock grant to vest each year in order to keep them at the company for a period of years until full vesting has occurred. Generally, the grant and vesting of your stock options have no tax or financial implications because an option is not property. However, the moment you “exercise” your options and purchase company stock, it will trigger a taxable event.

Stock options fall into two main categories: incentive stock options (ISOs) and non-qualified stock options (NSOs). Each type has different implications for planning and for tax consequences. Exercising NSOs typically results in W-2 income, meaning it requires you to withhold income and payroll taxes. Exercising ISOs, on the other hand, does not usually result in a W-2 scenario, though it depends on an option holder’s strategy. If you’re maximizing the potential benefits of your ISOs, exercising them usually creates alternative minimum tax (AMT) consequences. Of course, the ultimate sale of your stock will also have tax implications.

If you have stock options, you’ll want to develop a comprehensive strategy that takes into account factors such as tax consequences, your company’s outlook, your risk appetite, and the stage you’re at in your life and career.

What to Know About Your Non-Qualified Stock Options

Since NSOs are fairly straightforward and come with fewer IRS regulatory considerations, they tend to be more common in executive compensation packages. However, since they are almost always treated as ordinary income for tax purposes, they’re also less advantageous than ISOs and their more favorable capital gains rates. (This is an important difference – the highest federal ordinary income tax rate is 37%, while the top long-term capital gains rate is just 23.8% after including the additional Medicare tax on net investment income.)

If you’ve been granted NSOs, you have three main options:

  • Defer exercise
  • Exercise and hold
  • Exercise and sell

Many people opt to defer, assuming shares will rise. This allows you to avoid paying any tax until you have actual proceeds in the bank. At Wade Financial Advisory (WFA) we are also seeing an increase in privately negotiated deals that provide the cash needed to exercise options while transferring the ownership of the exercised shares to the third party who is providing the funding. WFA can help you understand the tax and financial planning considerations if these types of deals become available to you.

Choosing to exercise and hold can be a bit risky, as it means you’ll be required to pay tax upfront in order to benefit from lower capital gains in the future. If the share price plunges, you could lose money and find yourself upside down, having paid more in taxes than the value of the stock. Still, this can be the right option if you believe your company’s prospects are good, the exercise price is fairly low, and your immediate tax consequences at exercise are minimal. You may also want to carefully consider the merits of filing an 83b election if your stock grant allows for early exercise before the vesting date.

If you want to exercise and sell, you will need to consider how the timing of the sale impacts both current and future taxes, how it impacts your personal balance sheet, and your overall financial plan.

What to Consider With Your Incentive Stock Options

ISOs can pose a bit of a conundrum – they offer more opportunities for smart planning, but also more opportunities for mismanagement. That’s why it’s important to truly understand the best course of action for your particular circumstances. If you engage in savvy planning over multiple years, ISOs can be a source of significant tax advantages.

If you want to qualify for the preferred capital gains treatment on your ISOs, you’ll have to meet certain requirements. This includes holding your options for at least two years after they are granted, and at least one year from the date of exercise.

One important consideration with ISOs is that they are subject to the AMT, and that can significantly impact your cash flow. It can also raise your level of risk if the stock price drops. Although it’s possible to claim AMT back through a credit in later tax years, it is ostensibly an interest-free loan to the federal government that can put you in a liquidity crunch.

There are strategies you can use to deal with AMT risks, of course. Since the AMT may be reduced if you have more ordinary income, it may be sensible to exercise and hold your ISOs in years when you exercise and sell NSOs. Another potential strategy is to exercise and hold ISOs in years you plan to sell previously exercised ISOs that have met federal statutory requirements in order to create a favorable AMT preference on those shares sold.

As with NSOs, you may also have the opportunity to benefit from filing an 83b election or to benefit from private parties who can provide funding for the exercise of your options.

Final Thoughts on Optimizing Your Employee Stock Options

Regardless of the ISO or NSO strategy you undertake, the important thing is that you’re being strategic and intentional in order to optimize your individual financial circumstances. Simply “winging it” can take a beneficial employment incentive and turn it into an unfavorable scenario. If you want to truly maximize your stock options, make sure you understand exactly what you have, then engage in thoughtful tax planning over a multi-year period in order to effectively manage risks and optimize benefits. It may be wise to consult both tax and financial professionals as you build your strategy. WFA professionals not only help our clients understand the financial planning impact of exercising their options, but we also routinely help them model the current and future tax impacts of exercising their options.

At Wade, we are committed to helping our clients make well-informed financial decisions. If you believe our wealth management services may be a good fit for your needs, please contact us today.

This communication contains the opinions of Wade Financial Advisory, Inc. about the securities, investments and/or economic subjects discussed as of the date set forth herein. This communication is intended for information purposes only and does not recommend or solicit the purchase or sale of specific securities or investment services. Readers should not infer or assume that any securities, sectors or markets described were or will be profitable or are appropriate to meet the objectives, situation or needs of a particular individual or family, as the implementation of any financial strategy should only be made after consultation with your attorney, tax advisor and investment advisor. All material presented is compiled from sources believed to be reliable, but accuracy or completeness cannot be guaranteed. PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS. INVESTMENTS BEAR RISK INCLUDING THE POSSIBLE LOSS OF INVESTED PRINCIPAL.

Wade Financial Advisory, Inc. is an investment adviser registered with the Securities and Exchange Commission. Registration of an Investment Advisor does not imply any level of skill or training. A copy of current Form ADV Part 2A is available upon request or at www.advisorinfo.sec.gov. Please contact Wade Financial Advisory, Inc. at (408) 369-7399 with any questions.

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