Today’s post is another one of great interest, at least in my experience. Last one the focus was on Restricted Stock and Restricted Stock Units. The focus in this post is for Non-Qualified Stock Options. This information also came from that great webinar hosted by Kitces and PIMCO. Unfortunately, you need to be a member of his site to watch it, but I am not aware of any restriction if you wish to join.
As a reminder, part of the reason I feel this topic is so important is because it deals with specific strategies you can use to help you optimize your Non-Qualified Stock Options. I think I will just refer to them as NSOs from here forward to keep things a bit shorter.
Personally, I love NSOs. One of the reasons is because there is no risk to you until you actually exercise the option. Let me repeat that – There is no risk to you with Non-Qualified Stock Options until you actually exercise the stock options. I won’t go into the specifics with NSOs as you can go back to Episode 20 where I get into the details.
However, the reason there is no risk is you do not own or have custody of the NSOs until the point you exercise them. So, no taxes until then. And, if the actual stock price is lower than the Strike price at the time you are to exercise the option, you simply do not exercise them as it would be cheaper for you to buy them on the open stock market. Basically, you want to make sure the options are In The Money, which means they are above the Strike price. I’ll stop here because I will just be repeating the basics of NSOs, which is in Episode 20. But again, I love NSOs because there ain’t not no risk with them. I know that is not correct grammar, but I went to St. Vincent – St. Mary for high school and Kent State for undergrad. I blame them (please note sarcasm tone).
Enough of that little bit of background. How about we talk of three specific strategies to exercise your NSOs. Your last disclaimer to start. These strategies are in no order of importance. All I know in my years and years of doing this is that the best strategy is the one personalized to your individual situation. So, be sure to talk with your CFP® who is well versed in Equity Compensation and even taxes to make the best decision for you.
The first strategy is an easy one to follow as it is a time-based approach. Most NSOs are set with a 10-year exercise time frame. You have 10 years from the time the NSOs are awarded to you before you have to decide whether to actually exercise these options. Again, if the options are never In The Money there is no reason to exercise the options. For this entire scenario, we are assuming your options are In The Money.
One simple time-based strategy is to do nothing for the first few years. Then toward the latter of the 10-year period you start to exercise a percentage every year. In this example, you do nothing for the first 6 years. Then beginning in year 7 you start the process of exercising 25% of your NSOs every year. By the time the end of the exercise period comes you have exercised and are now in control of all of the shares.
Other examples are you could start after year 5 and exercise 20% each year, 1/3 after year 7, or exercise 50% each year after year 8. Again, totally up to you. Think of this as reverse Dollar Cost Averaging. Instead of buying a little bit every period going forward, you are exercising a specific amount over time and at different price points. Ultimately, you are allowing portions of the stock options to grow over time while also reducing your concentration risk exposure.
With this strategy there is no consideration of taxes or intrinsic value such as Black Scholes calculations. It is simply to make sure you exercise them so your In The Money options do not expire unexercised. This is a serious point because last data I saw showed that 11% of In The Money NSOs were allowed to expire without being optioned. I don’t know how much risk-free money was left on the table, but I’m sure it is significant. My point is the time-based strategy is a simple way to make sure you aren’t part of that number.
Okay, strategy number two is Price-Based. I’m sure you have already figured out how this works. You set a price point and if the NSOs hit that price you exercise them. Again, simple approach.
A simple example is your NSOs were awarded with a Strike price of $100 a share. You decide that you will not exercise them until they hit $150, or a 50% increase over the exercise period. Once they hit you go ahead and exercise them.
Within this strategy, you may also set up a stop loss sort of approach too. In this case, if the price drops from a previous high point you go ahead and sell. The example may be if the price rises to $140 and you decide if it drops to $125 you go ahead and sell too. This is similar to the guardrail approach to investing we talked about in the last episode in regards to RSUs and Restricted Stock.
The final strategy is my favorite. It is Tax-Based and it is just like it says – the focus is on optimizing taxes with exercising NSOs. I can’t say it enough – “It isn’t what you make; it’s what you keep.”
You may or may not remember what I mentioned earlier. There are no taxes on Non-Qualified Stock Options until you actually exercise them. When you do exercise them, the “gain” is taxed as Compensation Income, better known as Ordinary Income. The gain is the actual exercise price minus the Strike Price. Based on the example before, if the Strike Price is $100 and you exercise at $150, you have $50 for each share that is now taxed at full compensation income rates. If you happened to exercise 1,000 shares in this scenario, you now have an additional $50,000 of income.
Because you are now receiving additional taxable income, it is important to look at the entire tax picture for your household. Here is where we start doing things like filling up tax brackets. Another example, if you happen to fall in the 24% tax bracket and have another $30,000 of income before moving into the 32% bracket, well, it may make sense to exercise enough NSOs early to pay taxes at a 24% rate as opposed to having some it roll into the 32% bracket.
One key item to note – tax brackets will be changing in the next few years. The tax changes that dropped income tax rates in 2017 was permanent for corporations but temporary for individuals. The individual rates start changing in 2026, if I remember correctly. Plus, there is also the consideration of the government may accelerate that change. My point is to pay attention to present and even future tax rates. Again, no reason to tip Uncle Sam.
The goal with all of these strategies is once again to optimize your Non-Qualified Stock Options. Whether it is minimizing your taxes, reducing your concentration risk, getting some upside exposure but still limiting downside risk, it really doesn’t matter what your approach is, except that you have one. I would rather not hear you were part of the 11% who let his or her NSOs expire even though they were In The Money.
This seems like a good place to stop. Not sure what I will cover in the next episode. However, if you want to talk about your Non-Qualified Stock Options or any other Equity Compensation, feel free to reach out to me at any point.
As always, thanks for taking the time to read this. Please do not hesitate to reach out if I can be of help with your equity compensation-related questions. The easiest thing to do is to click the little green box that reads “Schedule a Meeting” that can be found at the bottom of every page on my website. Or, just click my Calendly link right here.
I’m Dan Johnson, CFP®, founder of Forward Thinking Wealth Management. I run a flat-fee financial planning and investment management firm located in beautiful Akron, OH. Although I am in Akron, OH, I work with clients regardless of location. I cater to owners of equity compensation positions who are looking to organize their financial lives, keep more of what they make, and do the things they want in retirement and even now.