Mapping Out Your Options

Treat these employee perks as a real part of your portfolio, not as a lottery ticket

Financial planner David Carpenter worries that many of his clients treat their employee stock options like play money. "A lot of people view them as only on paper," says the Littleton (Mass.) adviser. "The money's not real to them." Because of this attitude, he says, "I've seen people come into my office with millions of dollars in options in 1999 that aren't worth anything today."

The problem is many employees don't understand what stock options are--financial contracts that allow them to buy their company's stock at a specific price during a specific time period. Those who do, often wait to the last minute to take advantage of their employer's plans. In the past three years, about 2 million stock option plan (SOP) participants in the U.S. let their options expire worthless or declined to participate in their plans, according to a recent survey by Fidelity Investments. The survey also estimated that more than one-quarter of all plan participants do not understand how they work. Financial advisers say employees would get more from their options if they treated them as a real part of their investment portfolios instead of as lottery tickets.

First, a few basics. Most option grants have a fixed life, usually 10 years. They also have a "vesting period," usually two or three years that must pass before you can exercise your options and convert them into company stock. Each option also has a "strike price," which the shares of your company stock must exceed before you can exercise it. (Such an option is said to be "in the money.") Once these two hurdles are cleared, you should think of the options as real money and look at them as part of your stock portfolio, even if you haven't exercised them.

This last point is crucial. Consider the case of an employee at XYZ who has a $100,000 investment portfolio that is 60% in stocks and 40% in bonds. She also has 10,000 options of XYZ's stock with a strike price of $10 a share. If her XYZ options vest tomorrow when the stock is, say, $20 a share, the employee has an unrealized profit of $100,000. Add that $100,000 to her total portfolio and the employee actually has 80% in stocks and 50% of total assets in just one company--her employer. That's a powder keg. If XYZ goes bust, the employee would likely lose her job and the stock would be worthless.

ELIMINATING GUESSWORK. For safety's sake, advisers recommend company stock or vested stock options be capped at 20% of your total portfolio and 15% of your net worth, including real estate and bank savings. To avoid exceeding these levels, some advisers say you should exercise a portion of your vested options each year and sell the stock immediately.

But isn't there an optimal time to sell each option? Maybe so, but you need complex pricing models to do that--and some of the required inputs are still guesswork. That's why many advisers will counsel you to focus instead on getting the right exposure to your company stock in your portfolio. The average investor should treat any vested, in-the-money options as bankable compensation, not as a trading opportunity.

How much do you unload each year? It's best to have a "collar" of prices at which you'll sell, says John Bagley, a Scottsdale (Ariz.) financial planner. If you have an options grant with a strike price of $10 and the stock is worth $18, Bagley suggests setting exercise targets of $20, $25, and $30 on the upside, and $16, $14, and $12 on the way down. That way you lock in a gain no matter what. How much you sell depends on how much you have as a percentage of assets. If your vested, in-the-money options represent 50% of your net worth, you need to be more diligent about selling than if they're only 15%.

Exercising options triggers taxes, and the treatment depends on the type of options you hold. There are two kinds: nonqualified stock options (NQSOs) and incentive stock options (ISOs). NQSOs are more common, offered by 95% of companies with option plans. ISOs are often given in conjunction with NQSOs but usually only to high-level executives. Holders of ISOs can exercise only $100,000 in options a year (that's the cost to you of exercising, not your profits). Above that, ISOs are taxed as NQSOs.

The tax on NQSOs is straightforward. Once you exercise, the Internal Revenue Service treats any gain as ordinary income, even if you've had the option for years. So in the XYZ example--10,000 options, strike $10, stock $20--you would have an additional $100,000 in income. That's a hefty tax burden, especially if the gain pushes you into a higher tax bracket. But don't be tempted to hold onto the option as long as possible to avoid the IRS. Tax considerations should always be secondary to your asset allocation plan.

Exercising an NQSO and selling the stock you acquired are, for tax purposes, two separate transactions. You pay income tax on the gain in the option and capital-gains tax on any gains in the stock when you sell it. If you hold the stock hoping to earn capital gains, you're taking a big risk that you'll end up owing more tax than your stock is worth. Here's why: If the $10 options in XYZ are exercised when the stock is $20, the employee pays income tax on a $10 gain. If she holds the stock and it falls to $2 a share, she still owes the tax on the $10 gain. If she's in the 30% tax bracket, she owes more tax than her shares are worth. "There are a lot of stories of people exercising and holding and then going into personal bankruptcy when the stock collapsed," says Bruce Brumberg, editor of The moral: When exercising NQSOs, sell the stock immediately.

ISOs get trickier. If you exercise an ISO and hold your stock for a year, the IRS treats your entire profit, including the difference between the strike price and exercise price, as a long-term capital gain, taxing it at a maximum of 20%. So there's an incentive to exercise and hold stock. But you still face the risk of a big tax bill and stock market losses. If you sell ISO stock held less than a year, the IRS taxes it like an NQSO. Making ISOs even more complex is that their exercise could trigger the alternative minimum tax. That's why ISO holders should seek tax advice.

The option's expiration date should also play a role in your sell decisions. Generally, you should exercise those options closest to expiration first. That way the longer-dated options have more years to build value. With ISOs, however, it could be better to exercise the options with the smallest gains first and hold the stock, especially if you think the stock is heading for a big runup. If you're worried about a plunge, just exercise the options closest to expiration and sell the stock.

Keeping track of your options grants can be a chore. But it's necessary if you're to maximize your aftertax returns and maintain a diversified portfolio. Most companies hire brokerage firms to administer the programs, and they should provide you with statements showing your options, vesting, expiration, and strike prices. E*Trade (ET ) and Fidelity Brokerage Services provide this information online, and they'll even e-mail you once an option is vested.

If your employer hasn't retained a broker with such perks, bug your benefits administrator for records of each grant and then design your own spreadsheet. Free Web site allows you to track your options if you do the initial data entry.

Understanding your options plan is difficult, but it's well worth the effort, especially if you don't want millions of dollars to slip through your fingers.

By Lewis Braham

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