If you are lucky enough to receive stock options as part of your pay pack-
age--and luckier still to be watching their market price hit new highs--you may be wondering if it's time to cash in. It just may be. But before you rush to your broker, take a few moments to, well, consider your options. "People think of stock options as found money," says Joel Isaacson, a financial planner in New York. "But they are an important part of your overall financial plan."
As a rule, you should hold on to options as long as possible, so you can take advantage of future gains in the stock price. Options are leveraged, so if the stock goes from 20 to 30 in one year, shareholders get a 50% gain. But if you have an exercise price of 10, and you sell at 30, you make 200%. The extra leverage also makes options riskier than ordinary shares. Millionaires are made and undone overnight on their option packages, says Lanny Oppenheim, an attorney with Wien, Malkin & Bettex in New York, who counsels executives on financial matters.
Because of the added risk, options you collect on the job shouldn't make up too great a percentage of your assets. Generally, you should have no more than 40% of your assets in your company's stock, including options, common shares, and 401(k) holdings, says Jane King, president of Fairfield Financial in Wellesley, Mass. If you exceed the limit, pare back your options and diversify into other sectors. Even if your portfolio is essentially well-rounded, you may want to lock in profits if you have a substantial gain on your options.
You can hold on to options for too long. A common plan is for companies to issue executives options that expire in 10 years but may be exercised in 25% installments over four years. If you ignore them until the expiration date, you could be forced into exercising options when the company is at a trough in the business cycle and its stock price is low. The same could happen if you leave the company or are fired, since you get only a short window until you have to exercise. When you have only three years left before the option expires, or if you plan to leave the company in a few years, start looking for the best opportunity to act.
TAX FACTS. Also, consider the tax ramifications. Companies set up their programs differently. Most choose between offering incentive stock options (ISOs), which have certain restrictions but usually aren't taxed on the spread between the exercise price and the market price at the date of exercise, and nonqualified options, which require you to pay ordinary income tax on the spread as soon as you convert.
For tax reasons, some executives with nonqualified options look for periods when the stock pulls back temporarily to exercise, says Robert Gabele, president of CDA/Investnet Technologies Inc., a Fort Lauderdale (Fla.) firm that analyzes stock activity of corporate insiders. That way, they don't have to pay as much in tax right away and can benefit from capital-gains treatment on the anticipated rise in price if they hold the stock for a year. This strategy is especially good with high-dividend stocks. That way, you get the added income while you hold the shares. You should also think about exercising nonqualifieds over a few years to avoid being pushed into a higher marginal tax rate. With ISOs, there is a built-in incentive to hold the shares for a year after you exercise: That way, when you sell, you only have to pay the capital-gains tax. But watch out: Exercising ISOs may subject you to the alternative-minimum tax.
Most people exercise and sell options for reasons that have nothing to do with diversifying, reducing risk, or alleviating taxes. They simply want to buy a new car or fund a child's education, notes Oppenheim. If you work at a company where the CEO frowns on senior management selling stock, you may want to convert your options but hold the stock. If you are an insider, always check with your inhouse official who monitors Securities & Exchange Commission reporting requirements before selling. Companies mften give little guidance on managing options--since they want you to own the stock, says King. So it's up to you to figure out your own best options.
When It's Time to Exercise
-- When your company's stock represents more than 40% of your total portfolio
-- If you expect to leave the company within three years, and the stock price seems at a peak
-- If you could use the extra income from the stock's dividend
-- If exercising all your options at once will push you into a higher tax bracket or the AMT
-- If you hold nonqualified options and the stock falls, allowing you to save on taxes