Do you have employee stock options that you’re not quite sure what to do with? Should you exercise them and take the gain now (if there’s no gain, it’s a moot point) or hold onto them a little bit longer for potentially higher profits down the road? Here are some things to consider:
Can you exercise them?
Before you even think about whether you should, you might want to see if you could. There are two main reasons that the answer to that question may be “no.”
- The first is if your options aren’t vested, generally meaning that your employer won’t allow you to exercise them until a certain period of time (usually between 3-5 years) passes. This is basically a way of keeping you at the company for a bit longer and encouraging you to work for the long-term good of the company since you’ll directly benefit if the company’s stock price is higher after your vesting period.
- The second reason is if the current stock price is lower than the strike price, which is the price that your option allows you to buy it at. For example, if the current stock price is $75 per share and your strike price is $50 per share, then by exercising your option you can buy the shares at $50 and immediately sell them for the current market price of $75 for a $25 per share profit (less applicable taxes, fees, and expenses). That’s the fun part. But what if your strike price is $75 and the current market price is $50? In that case, your options are said to be “underwater,” which is about as fun as it sounds (and we’re not talking scuba diving here).
When will your options expire?
Just as you can’t exercise your options before they vest, you can’t exercise them after they expire either, which is pretty much what it sounds like. Many places will automatically exercise your options at the expiration date as long as they are “in the money” (the opposite of “underwater”) so you may want to check and see if that’s the case. If not, you’ll want to keep track and make sure you exercise them before they expire.
Do you have too much invested in your company stock?
This is a biggie because if you make this mistake, it can really wipe you out financially if the wrong things happen. As risky as the stock market is as a whole (remember 2008?), any individual stock is a whole lot riskier. After all, the overall stock market practically can’t go to zero, but an individual company can, and sometimes they do (remember Enron?).
No matter how safe and secure your employer seems to be, yes, this applies to your company too. Experts in behavioral finance say that we humans have a “familiarity bias,” which is a tendency to overestimate the value of things we know.
After all, you never know what can happen. Pick your villain. You can work for a company that makes great products in a growing field only to find that someone has been cooking the books (corporate crooks) or that a sudden change in the law has a devastating impact on your industry (politicians).
The risk is amplified when you consider that your job, and perhaps your pension, are tied to this company too. It’s bad enough to lose your job and much of your pension. It’s even worse to lose your nest egg at the same time. For this reason, some financial professionals suggest not even investing at all in the industry you work in much less your employer.
How much is too much?
So how much is too much? A rule of thumb is to have no more than 10-20% of your total portfolio in any one stock. In fact, pension plans aren’t even legally allowed to invest more than 10% of their assets in company stock. This is one reason that a lot of companies these days limit the amount of your 401(k) savings that you can have allocated to company stock.
What else would you do with the money?
If you have high-interest debt like credit cards, you’ll probably save more in interest by paying them down than what you’d likely earn by holding on to your options. Beefing up your emergency fund to 6-12 months of necessary expenses could be another good choice. In the unfortunate event that something did happen to your company, you’ll be glad you have some savings rather than underwater options.
Unless you have good reason to be particularly optimistic about your company’s growth prospects (don’t forget that thing about familiarity bias), diversifying the money into mutual funds or other stocks keeps you invested while significantly reducing your risk.
If you haven’t maxed out tax-sheltered accounts like a Roth or traditional IRA, you could use the proceeds from your options to fund them. You still have until April 15th to contribute for last year.
Will your tax bracket be higher now or in the future?
Remember that $25 per share profit we talked about earlier? Well, Uncle Sam will want his cut but the amount can vary. If you have non-qualified stock options, you’ll have to pay payroll and regular income tax rates on it. If you’re in the 24% tax bracket and about to retire next year in the 12% bracket, waiting that year could save you 12% in taxes.
On the other hand, if you have incentive stock options, there are more possibilities. If you exercise the option and sell the stock in the same year, you’ll pay regular income tax rates just like with the incentive stock options, but no payroll taxes.
However, if you exercise the options and hold the stock for more than a year (and 2 years from when the options were first granted to you), then when you eventually sell the stock, the difference between the price at which you sell the stock and the price at which you exercised the option is taxed at lower long-term capital gain rates (currently maxed at 20%) rather than higher ordinary income tax rates (currently maxed at 37%).
In the example we’ve been using, if you held the stock after exercising your options and the stock price continues going up from $75 to $90 then you’ll owe long-term capital gains taxes on the $40 per share difference between the current $90 market price and your original $50 strike price. However, you may owe alternative minimum tax under this scenario so consider consulting with a tax professional.
With either type of option, there could be some reasons to delay. But don’t let the tax tail wag the dog. These tax benefits can be outweighed by the risks of having too much in company stock or the benefits of using the proceeds to pay down debt or build up an emergency fund. The important thing is to understand each of your options (no pun intended) to decide what makes the most sense for you.