For many companies, offering employee stock options is a way of rewarding their employees while also aligning their interests with those of the company. Once reserved only for executives, stock options are now being offered to many rank-and-file employees as well. In fact, the number of people holding stock options has increased about nine fold since the late 1980’s. (1)
Your employee stock options can be a great benefit — if you know what to do with them. Here are three ways to maximize the value of your employee stock options, so you can avoid paying excessive taxes or leaving money on the table:
1. Understand The Tax Consequences
Albert Einstein once said that “the hardest thing in the world to understand is the income tax.” (2) Taxes can get complicated, even for someone like Einstein. However, not understanding how taxes work for your employee stock options could cost you a lot of money.
How Stock Options Are Taxed
There are two kinds of stock options, Incentive Stock Options (ISO) and Non-Qualified Stock Options (NSO). The main differences are who can receive them and their tax treatment. When NSOs are exercised, the difference between the grant price and the fair market value of the stock (called the “bargain element”) is taxed at ordinary income rates. Then, when the stocks are sold, the gains are taxed as either short or long-term capital gains, depending on how long they were held.
ISOs receive favorable tax treatment because they meet certain requirements in the Internal Revenue Code. Unlike NSOs, the exercise of an ISO is not a taxable event, though it could trigger the Alternative Minimum Tax. If the shares are immediately sold, the bargain element is taxed as regular income. Holding on to the shares is how you can get the tax break. Everything (the bargain element and the gains) is taxed at the long-term capital gains rate if you hold the shares for at least a year after exercise and do not sell them for at least two years after the grant date. (3)
Filing An 83(b) Election (4)
If your company stock is growing steadily, it might be a good idea to file an 83(b) election. An 83(b) election simply allows you to pay the income taxes due at the grant date instead of the exercise date.
For example, let’s say you are granted stock options at $25 and the price when you exercise them is $50. With an 83(b) election, you pay income taxes upfront on the $25 cost. Any growth from there is taxed as capital gains when the shares are sold. Without the election, you pay regular income taxes on the $50 price when you exercise the options. The election allows you to pay half as much at the regular income tax rate and push the gains made between granting and exercising into the lower capital gains tax rate.
Filing an 83(b) election can be beneficial if the value of your company stock is increasing steadily. However, if the prices drop or the company goes out of business, you will be worse off for having filed.
Smoothing Taxable Income
It’s important to coordinate your taxable events relating to employee stock options. Planning for income taxes generated from exercising options ahead of time can be extremely valuable to you. Smoothing taxable income over time to stay out of high marginal tax brackets can save thousands in taxes.
2. Get Your Dates Organized
If you’re like many executives, you have received a variety of restricted stock and stock options at different times and for different amounts. The restricted stock may have very different vesting dates than the stock options and the options may expire at surprising times as well. With so much going on, it’s easy to miss a deadline. A lot of people’s stock options expire because they plan to exercise them at the last minute only to get distracted or simply forget. Not exercising your valuable stock options is like throwing away money.
Being organized is crucial if you want to make the most of your employee stock benefits. There are strict deadlines if you want to take advantage of some of the tax savings listed above. Don’t leave money on the table. Staying on top of dates and amounts can save thousands in taxes and help avoid missing out on expired options.
3. Don’t Forget To Diversify
Employee stock options are a nice benefit, but you don’t want too much of your financial well being tied up in one company. I generally recommend holding no more than 10% of your portfolio in your company’s stocks and options. Why?
If the company performs poorly, it will depress the stock price and you may be laid off at the same time. There go your portfolio, your income, and your health insurance all at once. Unfortunately, this has happened to many people. Back in 1999 when Enron filed for bankruptcy, more than $1 billion in employee retirement savings simply evaporated. Many Lehman Brothers employees experienced the same thing as well. (5)
How Can We Help?
At Archer Investment Management, we understand employee stock options. We have experience helping clients minimize related taxes, stay on top of dates and deadlines, and diversify their portfolios. When it comes to your employee stock options, there is a lot at stake if you don’t do things right. Don’t try to do it all alone. Book an appointment with us online here so we can sit down and discuss how you can get the most out of your stock options.
Richard Archer is a financial advisor and the President of Archer Investment Management with more than eighteen years of industry experience. Largely working with successful individuals and couples, he specializes in providing comprehensive investment guidance and personalized care and attention to each client. Along with holding a Bachelor of Science in Economics and a MBA, he is a CERTIFIED FINANCIAL PLANNER™ certificant and a Chartered Financial Analyst®. He combines his advanced industry education and knowledge with his genuine care for people to provide clients with an exceptional experience. To learn more about Richard, connect with him on LinkedIn or visit www.archerim.com.