How To Know What To Do With Stock Options

Transcription

1 UNDERSTANDING STOCK OPTIONS From the Exercise and Harvest Strategy to the Capital Loss Whipsaw, here s what you need to know about options. By Monte Marti, CLU, ChFC, WealthStone Financial If employer stock options represent a significant portion of your wealth, then you should proceed with care. A good employee stock options strategy can help you with your retirement plans. But a poor strategy can squander assets and leave you saddled with tax obligations. WealthStone Financial WealthStone Financial This white paper sheds light on how to manage your stock options. While a financial advisor can help you determine when to harvest profits from your options and we recommend consulting with appropriate specialists having a basic understanding of options can help you to make smart decisions. WealthStone Financial

2 2 OPTIONS BASICS Many people receive stock options from their company. Since they are often granted to employees rather than requiring cash to obtain, you may not think of options as you do traditional investments that require funding. Yet, $100,000 worth of options can be just as important to your financial well-being as an investment of $100,000 in stocks, bonds and mutual funds. Thus, it is important to implement a stock options strategy that balances risk and return, enhancing after-tax profits and minimizing the potential for loss. What is a Stock Option? A stock option is a contract. It gives the option s holder, under certain conditions, the right to buy (and sometimes sell) company stock at a fixed price the exercise price or strike price. Usually, the exercise price is set to be the market price of the stock on the date the option is granted. T H E L I N G O STOCK OPTION a contract where the option s holder, under certain conditions, has the right to buy or sell a stock for a set price. Exercise Price the fixed price at which purchase or sale of stock can be made, usually equal to the market price of the stock on the date the option is granted. Call an option that gives the holder the right to purchase stock at a specified price. Expiration Date the last day on which an option can be exercised to buy or sell a stock at the exercise price. Vesting Schedule the time that must lapse before an option can be exercised by its holder. Intrinsic Value the amount of profit to be made by exercising an option to buy or sell stock. It is the spread between the market price for the stock and the exercise price of that stock. Time Value the value of the opportunity to continue holding an option in excess of its intrinsic value.

3 3 Options are valuable. When the market price of a stock rises above the option s exercise price level, for example, an option holder can profit. He can purchase the stock at a cost below the prevailing market price. Two common features of an employee stock option are the expiration date and vesting schedule. The expiration date is the last day on which the option can be exercised. It is the last day when the stock can be bought (or sold) at the exercise price. It is common for options to expire 10 years after they have been issued, though some employee stock options are issued for shorter periods, such as five years. You should read your company s employee stock options program benefits carefully. Many companies require that options be exercised within a certain number of days after terminating employment, or else they become worthless. The vesting schedule refers to the number of years that must lapse before all the options can be exercised by the options holder. The vesting schedule is similar to the vesting treatment of an employer s matching contributions to a 401(k) plan. Five-year vesting schedules are typical. To exercise an option, the holder provides the company with a notice of exercise and payment for the amount of stock at the exercise price. Some companies allow their employees to use company stock they already own to pay the exercise price. Some people obtain a loan to exercise the option and cover any associated taxes and fees. They repay the loan when they sell the acquired stock. You should read your company s employee stock options program benefits carefully.

4 4 Who Issues Them? Each company sets rules for its stock options program. It decides how many options will be granted, sets the exercise price, determines the expiration date and vesting schedule and decides other program features. What is the Benefit of Receiving Stock Options? The opportunity to profit. Options earn financial gains if the stock price appreciates from the time the options are awarded. Consider an example. Each recipient of a stock option grant is given the rules. The expiration date should be clearly stated when the options are awarded. Most recipients receive their options with time to exercise them, but note that some options terminate when the holder leaves the company. While some companies allow a grace period for option holders who end their employment, giving them time to exercise their options, this is not a universal practice. Bear also in mind that certain events, such as a corporate merger, can trigger an early expiration of any outstanding stock options. Let s suppose, hypothetically, that a company is a leader in supplying electronics and communication technology to the aviation industry. 1 At the beginning of the 21st century, the avionics company goes public and sets up an employee stock option program. Within a few years, the company s stock price more than quadruples in value. Suppose that an employee receives company stock options with a $40-per-share exercise price. Suppose, further, that the employee s options eventually become fully vested and, 1 This example is provided for illustrative purposes only and is not intended to reflect any actual company or situation.

5 5 in this example, the avionics company s stock reaches $70 a share. By exercising the $40 strike price, the employee buys company stock at a huge discount. He pays $40 for shares that trade on the market at $70. If the employee sells the stock shortly after acquiring it through his option, he profits $30 per share. (The actual net profit would be slightly less than $30 a share due to transaction fees). The above example illustrates what it means to be in the money with stock options. Being in the money occurs when the current market price for a stock exceeds the strike price of the option to buy that stock. Yes, options provide financial flexibility and may improve your financial wherewithal greatly. They may help increase your cash reserves, pay off debts, fund retirement accounts, fund your children s college education programs and serve as down payments to buy property. Stock Options and Your Taxes Of course, exercising options and reaping results profits will create a taxable event. So, before exercising options, it is important to talk to a financial advisor or a tax specialist. Such professionals have devised strategies to help options holders have sufficient funds on hand so they can exercise their options, buy the stock and pay any taxes that may be due. Most stock options are non-qualified. Exercising a nonqualified stock option creates a taxable event. Depending on the gain made by exercising some options, buying stock, selling that stock and netting the proceeds, you may jump into a higher income tax bracket for that tax year. The tax obligation is incurred in the tax year when the option is exercised. The obligation exists even if the stock purchased is not sold during the same tax year. The amount

6 6 of tax owed depends on many factors, and professionals should be consulted. But the key number is the spread or difference between the current market value of the stock and the exercise price provided by the option. In the avionics company example noted above, the option to purchase stock at $40 per share, when the stock sells for $70 a share on the day the option is exercised, creates a $30-per-share spread. This is considered by the IRS to be immediate gain. It is considered income in the year the option is exercised, and is generally taxed as employee compensation. Withholding is required for current employees. Income from the transaction will be included in the employee s Form W Tax information is provided for educational purposes only is based on our understanding of current tax law is not exhaustive and is subject to change. It is important to work with an experienced tax professional for your unique situation as Securities America representatives do not offer tax services. In the avionics company example, the option to purchase stock at $40 per share, when the stock sells for $70 a share on the day the option is exercised, creates a $30-per-share spread. OPTIONS STRATEGIES Proper timing is important when exercising options and selling appreciated stock. This section explores the financial and tax implications of the Exercise and Harvest strategy. It provides a framework for deciding when you should apply the strategy. Exercise and Harvest It is common for people to exercise stock options, buy stock and immediately sell some or all of the stock for a profit. This is known as a harvest. Harvest transactions provide

7 7 immediate cash. They can reduce your exposure to certain kinds of risk by immediately locking in gains. Let s suppose, hypothetically speaking, that you are an employee of the hypothetical avionic company mentioned earlier. You hold 2,000 call options. The options offer a $30- per-share spread between the strike price and the current market price. If you exercise these options simultaneously, buying and then selling all shares of stock, your gain is $60,000 (2,000 shares x $30 a share) less expenses associated with the transaction. You incur taxes on the $60,000 gain. But your take-home is substantial. You can use the net profit after taxes to make further investments, pay down some debt, make a large purchase, etc. Having long-term goals and a comprehensive financial plan can help you decide what to do with the money. Adjusted Basis Price The Exercise and Harvest strategy might appear to be a single transaction, since the exercise of stock options and subsequent sale of the stock seemingly happen together. But the IRS sees it differently. The IRS treats Exercise and Harvest as two transactions: (1) the exercise of a stock option and (2) the sale of stock. You will receive Form W2 that shows income (compensation) and Form 1099B that reports the stock sale. Even if you hold the shares and sell them at a later date, you will not face double taxation for the gain in value of appreciated stock. This is because the IRS lets you calculate your gain (or loss) after exercising your option using an adjusted basis price for the stock. You paid income tax upon buying the stock at a below-market price. But, in the future, you will be treated as if you bought the stock at that higher market price and not at the exercise price.

8 8 To illustrate the point, suppose you paid $8,000 to exercise an option. After selling the stock you report $12,000 as compensation in connection with the transaction. Your basis for the shares is $20,000. You pay income taxes on the $12,000 gain. If you sell the stock later for $24,000, you will have a capital gain of $4,000 at that time. Your overall profit is $16,000 ($24,000 - $8,000). But, you already paid tax on $12,000 of compensation. This basis adjustment prevents double taxation. Capital Loss Whipsaw Of course, holding any stock can lead to a loss if the value of the stock drops and this has tax implications, too. Taxpayers are allowed to deduct capital losses up to the amount of any capital gains, plus $3,000. If capital losses exceed $3,000, then excess losses can be carried over to subsequent tax years. A capital loss whipsaw occurs when you receive unfavorable tax treatment on both ends of a transaction. But this $3,000 limitation creates the possibility of a capital loss whipsaw. A whipsaw occurs when you receive unfavorable tax treatment on both ends of a transaction. It is not unusual for stock values of fast-growing companies to be volatile and create this type of situation. The whipsaw occurs if you exercise a non-qualified stock option and sell the stock later at a lower price. Suppose you paid $10,000 to exercise an option for stock worth $50,000. You would have to report $40,000 in compensation and pay income taxes. Suppose then that a year later you decide to sell your stock, but the price has dropped and you receive only $29,000.

9 9 You would have a capital loss of $21,000 ($50,000 - $29,000). However, due to tax regulations, you would only be able to deduct $3,000 of the loss per year. (This assumes that you do not have any long-term gains that you are either offsetting or carrying forward.) Not being able to deduct the total loss in the year that it is incurred, or possibly even over your lifetime, because of the amount relative to the $3,000-peryear limit, may turn out to be an unfavorable tax event. So, preventing a capital loss whipsaw is important. It is one reason why many investors choose to harvest profits by selling stock right when they exercise their stock options. Determining Value The value of a stock option generally has two components intrinsic value and time value. Each valuation plays a role in determining when options are ripe for harvesting. Intrinsic value is the amount of profit to be made by exercising an option to buy or sell company stock. It is the spread between the market price for the stock and the exercise price of that stock. If you own a stock option to purchase stock at $40, and the stock is currently trading at $70, then you have an intrinsic value of $30 per share (less transaction costs). Time value, on the other hand, is an abstract concept. It is the value of the opportunity to continue holding an option. Time value is crucial, and financial advisors try to weigh it carefully. For one thing, you have the opportunity to participate in the growth in value of a stock, even though you do not have to pay for the stock until you exercise your option. This delay in payment acts like an interest-free loan. More importantly, you have the potential for unlimited upside gain in stock price, but a limited downside if the price falls, so long as you hold onto your option.

10 10 To illustrate, imagine an option with an exercise price of $16 and the stock valued at $18 a share. If the stock value rises by $10, the option holder is looking at an additional $10 per share in profit. If the stock price falls below the $16 exercise price, then the option becomes worthless, but that is the extent of the option holder s losses. Someone who owns the stock stands to lose more if the stock price keeps falling. Other things relate to time value. Having time to make decisions increases the value of an option. Drawing near to the option s expiration date decreases its value. When to Exercise Option holders and their advisors use many approaches to determine when to exercise options. A common method involves assessing how a stock is likely to perform. Options holders who think that their company s stock price will increase typically delay exercising their options. They feel they can obtain a bigger profit by waiting. However, many employees overestimate their ability to predict their company s stock performance. Another method involves exercise and harvest based on personal needs. You exercise options and sell stock when you remodel your home or when your child s college tuition bill arrives. The exercise-and-sell-the-stock-now approach puts money in your pocket and protects you against possible loss of stock value. Still, holding options for as long as possible can be rewarding if the underlying stock price keeps rising. The problem is no one can accurately predict future stock prices. And if a stock is had a steady run in price for some time, then the risk of holding an option might exceed the risk of losing out on further gains to be made if the option is exercised.

11 11 Some advisors take a rule-of-thumb approach. Instead of exercising options as soon as possible, or as late as possible, the suggest holders exercise their options within two or three years of the expiration dates. OWNING STOCK IN YOUR EMPLOYER One pitfall of good stock option planning is the mistaken belief that a stock performs well when the company s business is doing well. Unfortunately, the stock price of an individual company is hard to predict. Time and time again, companies meet and exceed analysts earnings expectations only to see their stock price stagnate. Whatever the cause, a company s stock price can be volatile even when its operations are performing well. Given this uncertainty, it is wise to acknowledge the risk of holding too much company stock. You are not being disloyal to your company. If you have worked for your company for a long time and have accumulated a great deal of company stock and stock options, it is good to create a financial plan that can reduce your risk. Many advisors recommend that no single stock or stock option program comprise more than 20% of a portfolio. Add up the following elements:»» Value of stock held in your employer»» Value of unexercised options in your employer»» Amount of stock your employer has used to match your 401(k) contributions Together, these elements should not exceed 20% of your invested assets. If company stock and stock options exceeds that threshold, consider re-balancing your portfolio.

12 12 Balanced Asset Allocation In general, investments that have the potential for greater returns also carry a greater risk of decline. A prudent investor balances investments with growth potential (but higher risk) with investments with less growth potential (but lower risk). It might seem that the best thing to do is to make ultra-safe investments. U.S. Savings Bonds and Certificate of Deposits are examples of investments that carry little investment risk. The problem is these investments provide so little growth that they can lose significant ground to inflation. Investors should consider many kinds of risk and plot a course based on their goals. When the stock market is doing well, it s likely that your company s stock will share in the gains of the market. But if you have too much of your wealth in your employer s stock, your risk increases significantly as the stock prices increase. Suppose the hypothetical avionics company, mentioned earlier, saw its stock price rise from $20 per share to $70 per share within a five-year period. Though the stock seemed Many financial advisors recommend that no single stock or stock option program should comprise more than 20% of a portfolio. strong, most financial advisors would consider a portfolio loaded with this stock too risky. An employee with 30% to 40% of his nest egg invested in the stock takes a risk, especially since the stock has already experienced appreciation. He should rebalance the portfolio. Will the re-balanced portfolio outperform one invested heavily in one stock? No one can say. But, the risk of betting too heavily on one company is high.

13 13 Concentration Risk If stock options represent a large part of your portfolio, you may face concentration risk. The value of your options depends on the performance of their underlying stocks. If options represent only a small fraction of your wealth, and your wealth is otherwise well diversified, concentration risk may not be an important factor in your strategy. How you balance your risk depends on many other factors, such as your risk tolerance, short-term and longterm financial obligations, and time frame for using your money. But by exercising your options, selling the stock and converting the gain into cash, you can deploy the proceeds among a well-diversified portfolio of investment offerings. This proves to be less volatile in the long run. non-qualified stock option, the stocks you receive are taxed as ordinary income. Because you own the stock, you must come up with funds from your savings to pay the taxes. But, if the stock is held for more than a year before being sold, it can be taxed at a long-term capital gains tax rate, rather than as ordinary income. Exercise and Hold? Therefore, some have observed that they can reduce their tax obligations by exercising options early and holding stock as it climbs in value. Although superficially appealing, this Exercise and Hold approach has its drawbacks. It abandons any remaining time value in the options. It could also expose the options holder to possible economic loss if the underlying stock price drops below the exercise price. As suggested previously, the tax implications related to options are often misunderstood. When you exercise a The strategy also exposes the options holder to the possibility of a capital loss whipsaw if the holder reports

14 14 more than a small amount of income in connection with the exercise of options. The strategy to exercise options and then hold the stock works only for those who have a great deal of wealth. Such persons can afford to make the stock purchases and cover any resulting taxes and fees. In contrast, many people choose to delay exercising an option to delay paying taxes. This is a legitimate approach. Delaying an exercise of options can produce a genuine tax benefit, so long as the benefit is large enough to justify the risk of the option becoming worthless. If stock options expose you to only modest risk and are part of a balanced portfolio of investments, take tax deferrals into account when determining whether to harvest or not. But if your risk level is unacceptably high, then it may be prudent to exercise your options. Paying taxes sooner rather than later is the price to pay to lower your risk. CONCLUSION While options have some unique attributes, view them as you would any investment. You and your financial advisor should periodically review the options you have and their vesting schedules, strike prices and expiration dates. Look for opportunities to take advantage of increases in the value of your company s stock, as well as the best time to exercise an option and minimize its tax impact. Realize that even if you have options in a company s stock that has done well for several years, the future is uncertain. If the value of your options represents a significant amount of your total assets, it might be time to rebalance your portfolio and reduce your exposure to risk.

15 15 ABOUT THE AUTHOR Monte Marti, CLU, ChFC A former commodities trader, Monte S. Marti is President of WealthStone Financial. He is a Registered Representative with Securities America, Inc. and a Financial Advisor for Securities America Advisors, Inc. An accomplished marathon runner, Marti has completed the Boston Marathon, the New York City Marathon and many other races. Marti spends time working in his apple orchard, coaching his children's sports teams and volunteering in the community. He lives in rural Mount Vernon, Iowa, with his wife, Mollie, and their three children. WealthStone Financial WealthStone Financial ( is a financial services firm based in Cedar Rapids, Iowa. The company is dedicated to helping clients plan for a lifetime of wealth fulfillment and provides insurance reviews, income distribution strategies, pension reviews, tax planning strategies and more.

16 st Avenue SE Cedar Rapids, IA (319) (319) fax (800) Tax information provided herein is based on sources believed to be reliable but not guaranteed and is subject to change. Tax and legal services are offered in conjunction with qualified professionals. Securities offered through Securities America, Inc., member FINRA/SIPC. Monte S. Marti, CLU, ChFC, Registered Representative. Advisory services offered through Securities America Advisors, Inc. Monte S. Marti, Financial Advisor. WealthStone Financial, Inc. and Securities America companies are unaffiliated. Securities licensed in AL, AR, AZ, CA, CO, CT, FL, IA, IL, IN, KS, LA, ME, MI, MN, MO, MT, NC, ND, NE, NM, NY, OH, OR, PA, SC, SD, TN, TX, UT, VA, WA and WI. Insurance licensed in AZ, CA (Lic. # 0F04345), FL, IA, IL, IN, ME, NE, NV, PA, TX, and WI. Advisory licensed in IA and TX WealthStone Financial, Inc. All Rights Reserved.