Any investor should frequently ask questions, often about simple securities. Stock options from your employer complicate matters a lot more, and here’s what you should ask.
In the classic game show “Jeopardy,” contestants show their smarts by asking the right questions rather than by giving right answers. Executives wanting the most out of their stock options will do well with a similar approach.
Company stock options can make you money but you must ask questions. Typically, these options let employees buy shares in the company at a specific price by a specific date. An employee stock option is not generally traded on an exchange, and employees must often wait out a vesting period before they can buy.
An example: Your employer grants you options to buy 100 shares of its stock at $50 per share, known as the exercise price. Five years later, after the options vest, (the market price is $90. So you exercise your grant at the $50 level ($5,000 total outlay). If you want to turn around and sell the shares (your holding is now worth $9,000), you pocket the $4,000 difference.
To clarify your best steps, start with these four questions (preferably in partnership with your financial advisor):
What equity compensation grants do you hold: options or shares? Have you been granted options, either nonqualified (NQSO) or incentive (ISO)? ISOs may offer an income tax break if you hold them long enough before exercising, or selling. The more-common NQSO offers no such break. Options provide some flexibility over when you want to incur the taxable income.
Other tax considerations include:
- AMT implications on ISO exercises. Will it throw you into paying the alternate income tax, which adds back deductions to your return?
- Tax bracket creep from exercises
- Additional 0.90% Medicare tax on earned income
Or were you granted shares, either of restricted stock or restricted stock units (RSUs)? Employees often receive these grants according to a vesting schedule, sometimes based on performance milestones but often simply to encourage you to work side by side with your employer to increase the company’s stock price over the long haul. You are taxed on the distributions when the vesting occurs. For more, click here.
What role does your equity compensation play in your financial goals? Rather than let executive compensation drive your financial circumstances and objectives, flip that planning on its head. First, define your life’s goals, then let those goals drive your decisions on stock options or restricted stock.
What is your framework for making timely and profitable decisions? Have a disciplined approach coordinating your exec-compensation planning with your portfolio management. A plan tailored to your personal investing needs helps you focus on your true goals so you can make rational rather than emotional decisions.
What resources can help you? Even Alex Trebek can’t produce “Jeopardy” by himself. Your equity-compensation package needs a good production team, too. Seek solid advice along the way, and start with these five things you should know about stock options. We use a tool from StockOpter.com for our analysis:
- Your forfeit value, or the potential value you forfeit if you leave your employer
- The upside and downside leverage in portfolio value when the stock price changes 20%
- The stock price where you hit your financial goal
- Your concentration percentage in company stock, restricted shares and stock options – or how much of your total portfolio consists of stock in your company
- Your insight ratios, or the percentage of time value remaining in each stock option
Equity compensation requires a lot more thought than general investing. It can pay off if you ask the right questions and settle for nothing less than informed answers.
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Sheri Iannetta Cupo, CFP, is founding principal of SAGE Advisory Group in Morristown, N.J. SAGE is an independent, fee-Only firm specializing in providing busy professionals and their families with holistic financial planning and investment management services. Our firm philosophy: LEARNING and EDUCATING, with an emphasis on applying academic evidence to sensible, real-life investing; CARING for our clients in a fiduciary relationship; and SIMPLIFYING busy professionals’ financial affairs. Check out Sheri’s popular blog covering a range of financial-planning and life topics. For even more SAGE Advice in your life, connect with Sheri on Twitter, Google+ and LinkedIn.
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