Do you have goals of traveling the U.S., paying for your kid’s college or even early retirement? Stock options and employee stock purchase plans are one type of employee benefit that may help you reach those goals.
In order to make the most of these opportunities, you as an investor need to make smart decisions and manage your employee stock and stock options properly. You need to make sure you pay attention to the critical dates surrounding your stock options or risk losing out on the benefits these plans can offer.
To maximize your employee stock and stock options, avoid these 5 common mistakes.
Mistake #1: Concentrating Too Much of Your Wealth in Company Stock
You’ve likely heard the idiom “don’t keep all your eggs in one basket.” In the case of your money, you should avoid concentrating the majority of your wealth in your employer stock.There are a few reasons to diversify:
- You already depend on your employer for your livelihood (take-home pay, health benefits, and retirement), so it’s unwise to bet the rest of your wealth on the fortune of the same company.
- Concentrating your wealth in one stock exposes you to greater volatility (ups and downs) than a diversified portfolio.
To think that your company won’t ever have any financial hiccups is a folly. Enron and Lehman Brothers were two of the most high flying companies in their day. When Enron went bankrupt in 1999, over $1 billion in employee retirement savings was lost. If your company were to have a similar fate you may find yourself without a paycheck, benefits and your retirement savings gone.
John’s Take on Concentrated Stock
We can run an analysis to determine:
- What percentage your company stock makes up out of your overall wealth, and
- The effect a large drop of your company stock would have on your overall wealth.
If we determine you’re too concentrated, we’ll develop a plan to diversify your money while mitigating and minimizing the tax impact.
Mistake #2: Not Participating in Your Employee Stock Purchase Plan
An Employee Stock Purchase Plan, or ESPPs, allow investors to purchase company stock, many times at a discount to the current fair market value. The discount could range anywhere from 5% to 15%. Some plans also offer a “look-back option,” which gives you the option to purchase company stock using the price on the first or last day of the “offering period.”
For example, if the price of company stock ends 5% higher on the last day of the quarter versus the first day, you would use the price of the stock on the first day of the quarter. Add in the discounted purchase price and you may be purchasing stock at a steep discount.
This is potentially a great benefit! In some cases, you may be able to sell the stock immediately after purchasing, which is almost a no-brainer. In other cases, you may have a required holding period of 1 year or more.
John’s Take on Employee Stock Purchase Plan – ESPP
Before you participate in your ESPP it’s important to analyze your debt levels and cash flow to determine if you have enough cash flow to purchase stock. It’s also important to decide whether the current stock price offers a good value for you to buy, especially if there is a 1 year or more required holding period.
Finally, you should review this regularly, as your cash flow position may change and you can make changes to your ESPP.
Mistake #3: Allowing In-The-Money Stock Options to Expire
Stock options allow you to purchase a pre-determined amount of shares in company stock at a pre-established price, known as the exercise price. Most times there is also a vesting schedule associated with your stock options, meaning they are not physically yours until a certain date. Once vested, there is a certain period of time for which you have to exercise your option to purchase company shares.
“In-The-Money” stock options are stock options where the exercise price is lower than the current market price of the stock. For example, if you had the option to purchase 500 shares of company stock at $30 and the stock current trades at $50 in the open market, your options are $20 in-the-money. Should you exercise the option and immediately sell the shares on the open market you’d earn a healthy $10,000 pretaxed profit.
Since the long-term trend of stocks is to go up (‘Merica!), you may be tempted to wait as long as possible to exercise the options and maximize profits, as well as put off taxation. However, this is not always a smart decision. We know that in the short-term markets, and especially individual stocks, can be very volatile. One bad “tweet” could send a company’s share price tumbling.
Furthermore, life tends to get busy and you may forget to exercise options before the deadline. Once the time has passed, you’re finished. This could potentially cause you to leave money on the table!
John’s Take on In-The-Money Stock Options
There is a lot to be analyzed with stock option transactions. Not only will you determine whether or not you will exercise based on the current market price of the stock, it’s also important to consider your personal tax situation. This is the type of scenario where having a trusted, fee-based fiduciary advisor can really pay.
We’ll develop an action plan and continually monitor your employer stock and personal tax situation to determine when the best time to exercise your options is. Automated reminders and regular check-ins keep the conversation at the forefront and help you avoid missing critical dates.
Mistake #4: Miscalculating Tax Consequences
When it comes to stock option grants there are two kinds: incentive stock options (ISOs) and nonqualified stock options (NSOs). NSOs can be offered to non-executive employees and outside directors. ISOs are only offered to executive employees of the company. ISOs are given special federal tax treatment because they meet specific rules described by the Internal Revenue Code.
Taxation on Non-Qualified Stock Options
- The grant of a NSO is not a taxable event.
- Taxation of NSOs begins at the time of exercise. The difference between the market value of the stock and the exercise value is considered compensation and taxed at your ordinary income tax rates.
- The sale of stock acquired by NSO also triggers a taxable event. If stock is held for longer than 1 year from exercise, the sale will qualify for long-term capital gain rates. Otherwise the gain is taxed as short-term.
Taxation of Incentive Stock Options (ISOs)
- The grant of a ISO is not a taxable event.
- No income taxes are reported at the exercise of the options as well.
- Taxation begins at the sale. If shares are sold immediately after being exercised, the difference between the market value at the time of exercise and the exercise price is taxable as ordinary income.
- The gain on stock is treated as a long-term capital gain if the following rule is followed: Stock must have been held for 12 months after the exercise and should not be sold until two years after the grant date. If this rule is violated, it is known as a Disqualifying Disposition.
This holds true for ESPPs as well. If you immediately sell your shares, you will recognize profits as short-term capital gains and they are taxed at your marginal tax rate. Depending on your capital needs and the longer-term outlook for the stock, you may want to hold out for the long-term capital gains rate.
John’s Take on Miscalculating Tax Consequences
Taxes alone are complicated. Now throw in ISOs, NSOs and ESPPs (confused yet?) and it’s easy to see how investors could miscalculate or make tax mistakes. This is why we work closely with competent CPA professionals and plan ahead to mitigate and minimize tax impacts. When you create a plan you can avoid rushing to make decisions at the last minute.
Mistake #5: Not Having an Exit Strategy
I spoke earlier about letting time pass by without exercising in-the-money options and also about making tax mistakes. These poor results are the product of not having an exit strategy or plan in place.
As Stephen Covey wrote in his book, “7 Habits of Highly Effective People”, you need to “begin with the end in mind.”
With stock options and employee stock purchase plans, things can get complicated and confusing. The worst thing you can do is be an ostrich and avoid taking action. The best thing you can do is to work with competent professionals and develop an action plan ahead of time. By doing so, you can simplify the process and hopefully achieve great outcomes with your benefits.
Answer these 5 questions to effectively begin planning your exit strategy:
- What are your short-term (paycheck to paycheck) money needs and how much non-mortgage debt do you have?
- Do you own Non-Qualified Stock Options (NSOs) or Incentive Stock Options (ISOs)?
- When do my stock options vest and what is the exercise price for company stock?
- How much of a discount can I purchase company shares for and what are the required holding periods?
- What is the long-term outlook for the company and what is the short-term outlook for the overall stock market?
Have Questions About Your ESPP or Stock Options?
Being educated about the important points of your ESPP and Stock Option Plan can help you make smarter decisions. If you have more questions I’m happy to help you! I make getting answers super easy, without having to talk to some high-pressure sales person. Just use the secure contact form to ask a question and I’ll get back to you via email within 48 hours to help point you in the right direction. Remember, it’s free to contact me. Plus, I am a fiduciary advisor putting your personal needs first and foremost!
Lastly, like all humans — I do make mistakes. If you see one on this post please reach out and let me know. I’m happy to admit when I’m wrong and update my blog! Also, if you’re an investor and have questions please feel welcome to reach out as well. I offer a free wealth discovery meeting where we can discuss your personal situation and how to get you moving in the right direction!
John Weninger, CFP®
Endowment Wealth Management, Inc.