I want to tackle a relatively simple topic here – Exercising stock options. As always, there is a super simple way to exercise your options. If they are in the money, you just go ahead and exercise them before they expire. Any increased value above the award value is treated as compensation income, so it becomes taxable. This actually is an okay way to exercise your options if you want to keep things as simple as possible. However, if you want to optimize things and also to keep your tax bill a bit lower, then you may want to read on.
First things first. When I talk stock options I am referring to nonqualified stock options of publicly traded companies. This is what I see with my clients. And since I cater to clients who have equity compensation, I see it frequently. And if you are wondering which you have, odds are you have nonqualified as 95% of stock options are nonqualified. Obviously, check with your benefits people to confirm.
Next, there are two things I see with stock options I want to mention before we get into specific tactics with exercising options. The first is to clear up some confusion I see and hear about with stock options. If your employer offers you stock options – TAKE THEM!!! You would be shocked how often I hear stories of someone turning down stock options. I understand there may be some unique times when it makes sense not to accept stock options offered by your employer, but I’ve never come across one. The key to remember with stock options is there is NO risk for you to accept them.
When you receive stock options, there is no tax consequence. The only time there is a tax consequence is when you decide to exercise your options. The IRS doesn’t care until the point of exercising the stock options. Now, if your options are in the money, meaning they have increased in value above the grant price, odds are good you should exercise them. If they have dropped in value since the grant, meaning you are not in the money and it would be cheaper to buy them on the open market, there is nothing to do. Since you do nothing there is no exercise and no tax bill.
The next item to mention is for you not to be a number. Eleven percent of in the money stock options are allowed to expire every year without being exercised. I’m not sure why this number is so high, but my guess is people just aren’t paying attention, both the options holders and the advisors. Again, I’ve never come across a reason why a client should NOT exercise options that are in the money.
Now that we have some background out of the way, let’s talk more about tips for exercising stock options. The assumptions I’m using here are you are fully vested with your stock options, meaning you have the power to exercise them, and the exercise time period is 10 years.
The first tip is if you are planning to continue to hold the stock with hopes it will grow, it may be in your best interest to wait before you exercise it. A big reason to maintain them in “option state” before exercise is in case they drop below the grant value. Leaving them as a stock option allows a type of downside protection that simply does not exist if you hold the shares. It also allows you to defer the additional compensation income that comes into play with exercising and the associated taxes.
Your second tip focuses on reasons to exercise them as soon as you can and continue to hold onto the stock. Doing this means you have to pay taxes based on the compensation income when you exercise them, but the change in value between exercise and when you actually sell them is treated as capital gains. Capital gains taxes are typically lower than compensation income rates. A reason to exercise them early is the shares may be at a historically low level and you are convinced the stock will go up in value. This can be a rather dangerous strategy as no one knows what will happen with your stock price. Maybe a better reason to exercise sooner than later is your compensation income is relatively low right now. If your income is projected to increase then it may make sense to accelerate compensation income from your stock options, especially with individual tax rates at low levels right now. Ultimately, this is a personal decision you need to review with your Certified Financial Planner™.
Probably the best tip to exercise your options is based on a mathematical model that prices options. If you are a super finance nerd you may be familiar with the term Black Scholes. This mathematical model estimates the variation over time of financial instruments. It is a solid model and was even the basis for a Nobel Prize in economics. It factors in strike price of the option, the current stock price, time to expiration, the risk-free rate, and the volatility of the stock. I won’t go through an awful exercise of running the formula as there are plenty of calculators online. Just know the closer the Black Scholes number gets to 100, the more it makes sense to exercise your options.
I just want to reiterate a few things we already discussed. First, do not be part of the 11% of options owners who allow in the money options expire every year. Next, be sure to understand the rules with how and when you can exercise your options. The rules will come from your employer in a stock options document you should receive with the options award. Finally, make sure you are making a decision to exercise based on your personal situation. Take the time to talk with your CFP® and be sure to understand it fully before making the decision. There is no one size fits all with stock options.
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.