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Strategies for Exercising Non-Qualified Stock Options, Ep 43

In the last episode, the focus was on restricted stock and restricted stock units. The focus in this episode is on non-qualified stock options. Part of the reason I feel this topic is so important is that it deals with specific strategies you can use to help you optimize your non-qualified stock options. Personally, I love NSOs because there is no risk to you until you exercise the option. I won't go too far into the weeds as you can go back to episode 20 where I get into the nitty-gritty details. There is no risk because you do not own the NSOs until the point you exercise them so no taxes until then either. 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. Today I'll cover three specific strategies to exercise your NSOs but the best strategy is the one personalized to your individual situation. So be sure to talk to your CFP to make the best decision for you. 

You will want to hear this episode if you are interested in...

  • The time-based strategy [2:51]
  • Price based strategy [5:13]
  • Tax based strategy [6:21]
  • This week’s FLASHBACK [9:20] 

Exercising over time allowing stock to grow and reducing concentration risk

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 timeframe. You have 10 years from the time that NSO is awarded to you before you have to decide whether to actually exercise these options. If the options are never in the money, there is no reason to exercise those. 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 ten-year period, you start to exercise a percentage every year. In this example, you do nothing for the first six years. Then beginning in year seven, 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. Ultimately you are allowing portions of the stock options to grow over time while also reducing your concentration risk exposure.

Exercising by Price or Tax Advantage

Strategy number two is price-based. You set a price point and at the end of those hit that price. You exercise them again, a simple approach. And again, also assuming everything is in the money. A simple example is your NSOs were awarded with a strike price of a hundred dollars a year. You decide that you will not exercise them until they reach $150. This is similar to the guardrail approach to investing talked about in the last episode.

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 and you're probably tired of me saying it, but I'm going to say it again. It isn't what you make. It's what you keep. 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. The gain is the actual exercise price minus the strike price. Based on the example before, if the strike price is a hundred dollars and you exercise at 150, you have $50 for each share that is now taxed at full compensation income rates. Because you are now receiving additional taxable income it is important to look at the entire tax picture of your household.

This week’s FLASHBACK: Signing Documents

I was a warehouse guy at the Wicker Company, this mostly involved delivering furniture. The company was primarily a patio furniture company in the spring and summer. As the delivery guy, I went to a lot of different houses. We often had repeat buyers. I remember we did free deliveries within a certain radius, maybe 25 or 50 miles. Every day one of the senior warehouse guys would map out the deliveries. As part of his responsibility, he would make a list of deliveries. The delivery sheet was usually in black or blue ink because those were the company pens. We then used red pens when out on delivery to make any notes. Once we arrived at the house, when the delivery was complete, we had the customer sign in red since that was the color we kept in the delivery truck. 

Red pens were fine for most people, but not for one family that we delivered to multiple times. It must've been the third or fourth trip when I realized the husband would not sign the delivery forms with our pens. He happened to have a black pen on him and he used that instead. On the next delivery to that house, his wife explained he would never sign anything in red, as it meant he was losing money! Just an odd story but after that, I always kept a black pen for customers who only wanted to sign documents in the same color that represents profit. 

Resources & People Mentioned

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.