Stock Options: Valuable, But More Complex Than You Might Think
If you work at a company that provides stock options, you may be wondering what role they should play in your investment portfolio. Are they a good opportunity that should be maximized? A hazardous one to minimize? Somewhere in between?
The answer is complex, depending on both the type of stock options being offered and the particulars of your financial situation. But there are some general ideas to keep in mind to take advantage of these options without getting burned.
Before we differentiate between stock options, their tax implications, and the like, let’s reiterate a foundational principle of investing: diversify your assets. The fortunes of any one company can ascend skyward for a while, only to plummet to earth when business conditions change. Even though you may feel supremely optimistic about your company’s prospects, it’s subject to the same market forces as any other stock. History is littered with the names of companies that once seemed invincible but are now out of business. Imagine how you’d feel if you bulked up on the stocks of Blockbuster, Kodak, Toys R Us, etc., and held onto them until the bitter end.
Types Of Stock Options
Stock options can be provided for companies not yet trading on a stock exchange or companies that are already selling shares publicly. For example, startups would offer stock options for stock that is still private. If you’re part of such a company, you may have been granted significant stock options as a form of compensation.
When you receive stock options from your company, you don’t own the stock. Rather, you own the right to purchase the stock a specified price. In fact, when you are granted the stock options, those often don’t become yours until after they vest. Vesting is the process of earning the rights to an asset, like stock options or employer-matched contributions to your 401(k) over time. Companies often use vesting to encourage you to stay longer at the company and perform well.
Only after you have exercised this right (usually requiring an out-of-pocket capital outlay from you) do you own the stock. After you’ve exercised this right, you can immediately sell the stock or hold onto it while you’re still working with the company.
Legally, the important distinction is whether the stock option can take advantage of certain favorable tax rules. Those that can’t are called “non-qualified stock options” (NSOs); those that can are called “incentive stock options” (ISOs). Employees don’t need to pay taxes on ISOs when they exercise the stock. But employees with NSOs do so once exercised, paying taxes at ordinary income rates.
Sell Or Hold?
Whether it makes sense to hold onto a stock or not once you’ve exercised your option is a question of your own personal finances, the amount of exposure you have to the company, your risk tolerance, and taxes.
- Personal finances – How does this asset fit into your plans? Do you need these funds to pay off a debt, save for a home, or invest in a 529? Maybe you don’t need these funds at all and they’re gravy for you. Consider the goal of the money and how it could best be allocated.
- Exposure – Will more of your options vest in the future? Will you be paid more in stock option for future bonuses? If the stock represents a significant amount of your overall holdings, say greater than 10%, you may want to consider reducing your ownership.
- Risk tolerance – Are you comfortable betting heavily on one company? How would you feel if you sold your holdings and the shares tripled? What if you held onto them and they dropped 70% in value?
- Taxes – Selling a stock that you’ve held for less than a year subjects you to ordinary income taxes on the gain — up to 37 percent on federal taxes — while holding it over a year holds it to 15 percent (20 percent if your annual income high enough). That doesn’t even include the state taxes you may owe.
Remember, these are just some of the factors you should consider when reviewing your options. We’re happy to discuss your “options on options” anytime. Just book a free meeting and we’ll help you sort it out.
Learn more about stock options and restricted stock units in Episode 10 of The Build below!
Lake Road Advisors, a Fee-Only, independent financial planning firm with offices in Corning, NY, Ithaca, NY and Portland, OR works with clients virtually all across the country. Paul Sydlansky, the founder of Lake Road Advisors LLC, has worked in the financial services industry for 20+ years. Prior to founding Lake Road Advisors, Paul worked at Morgan Stanley in Manhattan for 13 years. While at Morgan Stanley, Paul was a senior-level manager within the Institutional Equities Department. In 2018 he was named to Investopedia’s Top 100 Financial Advisors list. Paul received a Bachelor’s degree in Economics from Marist College and holds an MBA from New York University Leonard N. Stern School of Business. Paul is a CERTIFIED FINANCIAL PLANNER™ and a member of the National Association of Personal Financial Advisors (NAPFA) and the XY Planning Network (XYPN).