Financial Insights

Unlocking the Value of Your Company Stock Options: A Comprehensive Guide

Continuing our series on understanding and optimizing your equity compensation package, this week we focus on the nuances of equity stock options. In an earlier article, we outlined the various forms of equity compensation accessible to employees and the factors to consider when integrating these benefits into our comprehensive plan. Whether you’re a seasoned professional or just starting to explore the possibilities of your company stock options, your advisor can help demystify the process so that you can make informed decisions that align with your financial goals.

Stock options offer a unique opportunity for employees to share in the success of their company without the need to invest upfront capital. But how exactly do they work, and what do you need to know to make the most of them? Let’s break it down.

Understanding Stock Options

When your company grants you stock options, they’re essentially giving you the right, but not the obligation, to purchase company stock at a predetermined price, known as the strike price, at some point in the future. This allows you to potentially buy shares at a lower price than their current market value, providing an opportunity for financial gain as the company grows and its stock price appreciates.

Vesting and Exercise

Before you can exercise your options, they must first “vest”, meaning that you become eligible to exercise them. Vesting typically occurs over a set period of time, often four years, beginning with a one-year cliff before any shares are vested, followed by monthly or annual vesting thereafter. Once vested, you have the choice to exercise your options by purchasing the stock at the predetermined strike price.

Over time, if you remain with your employer, you may end up with multiple grants with different strike prices, each of which will be subject to its own vesting schedule. For some, this type of compensation and the value that the shares represent can be an important source of personal wealth.

Option Exercise Strategies: Cashless Exercise, Sell to Cover, Buy and Hold

When it comes to exercising your stock options, there are differentl strategies to consider, each with its own advantages and implications.

A “Cashless Exercise” involves selling all of the shares acquired through the option exercise immediately upon exercising. The proceeds from the sale are then used to cover the cost of exercising the options (purchasing the shares), including any taxes owed, leaving you with cash. This strategy allows you to avoid the need to come with the money to exercise the options, but it also means you won’t retain any shares of the company stock. A Cashless Exercise may make sense if you have an immediate need/expense that can be satisfied by the net cash generated by exercising your options.

“Sell to Cover” is similar to a cashless exercise but involves selling just enough shares to cover the cost of exercising the options and any taxes owed. This strategy allows you to retain ownership of a portion of the acquired shares while still covering your expenses and makes sense where you don’t want to come up with the funds separately to exercise the options in order obtain some shares of your company’s stock.

A “Buy and Hold” strategy involves exercising your options and holding onto the acquired shares for an extended period. This strategy allows you to potentially benefit from future appreciation in the stock’s value, but it also exposes you to market risk and may require upfront capital to cover the cost of exercising the options. This strategy may make sense where you want to gain ownership of all of the particular shares vested (you have a positive outlook on the stock) and are also comfortable paying for the cost of exercising the options, including any income taxes, from other sources of funds.

Each strategy has its own considerations, and the optimal choice will depend on your individual financial situation, investment goals, and risk tolerance. It’s important to carefully evaluate each strategy, the type of stock options you have vesting and consult with your wealth advisor to determine the approach that best aligns with your objectives.

Income Tax Implications

The income tax implications of exercising your stock options can significantly impact your overall financial plan and the exercise strategy you may choose. The taxation of stock options varies depending on whether they are classified as Nonqualified Stock Options (NSOs) or Incentive Stock Options (ISOs).

When you exercise NSOs, the difference between the strike price and the current market value of the stock is considered ordinary income and is subject to federal, state, local, Social Security, and Medicare taxes in the year that you completed the NSO exercise. As a result, exercising NSOs means that you may have more taxable income in the year that you exercise. For high earners over age 65, additional Medicare premium surcharges may also apply.

The cost basis of any shares held as part of an NSO exercise is “stepped- up” to price the stock is trading at on the exercise date. In order to receive long-term Capital Gains tax treatment above the stepped-up cost basis on the future appreciation of any shares held after exercise, you must hold onto them for at least a year and a day. Due to their tax treatment, NSOs are not typically good stock options to buy and hold as shares.

Qualifying Dispositions and ISO Tax Treatment

ISOs offer potential tax advantages vs. NSOs as the difference between the strike price and the market value at exercise is not subject to ordinary income tax at the time of exercise.

In order to qualify for the preferential tax treatment of ISOs, however, you must hold the shares for a minimum specified period of time, typically one year from the exercise date and two years from the grant date. If these “qualifying distribution” requirements are met, then any gains from the sale of the shares will be treated as long-term capital gains, which are typically taxed at lower rates than ordinary income.

A curve ball to ISOs is that they may trigger Alternative Minimum Tax (AMT), which may defeat the benefit of attempting to achieve lower, long-term capital gains tax treatment. ISOs are good candidates to be exercised and held as shares for the long-term where you can avoid triggering AMT tax.

With proper planning, you have the ability to combine different exercise strategies to take advantage of the preferential tax treatment ISOs provide, and avoid triggering AMT taxes. This is typically achieved by combining different exercise strategies or if you have both types of stock option grants, implementing the optimal strategy on correct option type. One idea would be to execute a cashless exercise on NSOs, generating cash and realizing ordinary income, and then using that cash to buy and hold ISOs for the long-term.

Making Informed Decisions

Stock options offer the ability to participate in the potential upside a stock provides, but also creates the risk of being overlay concentrated in one stock where you may have some emotional attachment, particularly if you continue execute buy and hold strategies with the same company over multiple years. Once you’ve exercised your options, you’ll also retain the need to make decisions on whether to hold or sell any acquired shares.

Navigating the world of stock options can be complex, but with the right knowledge and guidance, you can maximize the value of this important component of your compensation package. Your decision on how to incorporate your option grants should be based on your individual financial situation, including factors such as your overall investment strategy, tax considerations, and risk tolerance.

By understanding the basics of stock options, including vesting schedules, tax implications, and exercise strategies, we hope that you can make more informed decisions that support your long-term financial goals. If you have any questions or need personalized guidance on your equity compensation plan, don’t hesitate to reach out to your ACM Wealth Advisor.

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.


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