Employee stock options are a very valuable form of employee compensation. They are also one of the most complicated. To develop a strategy for cashing them in, you must consider many factors, including the tax consequences of exercising, the outlook for your company, your other assets, and your goals. A natural aversion to taxes and employer loyalty sometimes make it hard for employees to sell their options when they should, and that can be a big mistake.
Stock options help build wealth
Employee stock options permit you to purchase a set number of shares of your employer’s stock at a set price, called the strike price. Options accumulate value as the market price of your employer stock exceeds your strike price. The difference is your profit. As your employer stock price rises over time, your profit increases. At the time you cash in your options, your profit will become taxable income.
We see many long-time employees who end up with huge profits in their options. Often the value of their options represents 50-80% of their net worth. It is natural to feel loyal to the company that has helped you accumulate such wealth. This can make it difficult to cash in your options. In addition, when the profits are large, so are the taxes. While strategies exist that can help you minimize the tax consequences of exercising your options, they are limited. In most cases, if you have large profits, you will have to pay large taxes.
Diversification vs. Avoiding Taxes
The aversion to paying taxes can cause you to lose sight of one of the most important rules of investing-diversification. Anytime you have a significant amount of your wealth tied to one company’s stock, you are subject to an enormous amount of risk. Stock prices are affected by many factors. Even the best run company can see its stock price fall due to a recession or the whims of investor sentiment. Take the example of Northrop Grumman. Over a long period of time, the company’s stock has greatly increased in value. But, during the most recent recession (2003-2003), the stock price fell 40%, from a high of $62 to a low of $37 (split adjusted). It took almost four years for the stock price to make up that lost ground.
If such a downturn in the stock price occurred at an inopportune time, you could lose more value than you would have had to pay in taxes. Many people are counting on their options for college expenses, retirement, or other goals. In addition, options have an expiration date. If the stock price drops before your expiration date or before you need the money for one of your goals, there may not be time for the stock price to recover.
A prudent approach
You need to take a prudent approach to your options. When investing money for our clients, we hold no more than 5% of a portfolio in any one company. Because of the wealth building effect of options, this tolerance can be increased. One of the factors to consider in determining the appropriate amount to hold is the outlook for the company and its industry. We would hold more of a company with steady growth than we would a volatile startup. We would hold more for a young person than someone nearing retirement. We would hold more for a person who had other invested assets to meet upcoming goals such as college expenses, than for someone who was depending solely on their options.
Once you have determined how much you can prudently continue to hold, you need a plan for liquidating the rest. This plan should include strategies to minimize the taxes. Those strategies may include:
- Plan to exercise and sell in years when your overall income will be less.
- Plan to spread the income across multiple years to pay taxes on the income at lower brackets.
- Look for opportunities to reduce or defer other types of income to offset the results of the stock sales.
- If they are incentive stock options, exercise and hold some shares to qualify for long-term capital gains.
While these strategies can minimize your taxes, they will not eliminate them. In most cases, such strategies do not exist. At some point you are going to have to pay the taxes. That time may be now.