Did You Know...
Should I Exercise My Stock Options?
When exercising stock options there are typically two methods of doing so:
Exercise, sell the stock, and take the cash. This is usually done through a 'cashless exercise' where you do not have to use any cash up front. A proportionate amount of shares is deducted to cover taxes and fees and you net the proceeds.
Exercise them and hold the stock. This typically requires you to use personal cash up front, although some plans have alternative methods of doing this (buying on margin).
When deciding which method to use, you must first identify if you have qualified or nonqualified stock options. Qualified options are referred to as ISOs and have different tax implications than nonqualified stock options. We'll address each of these separately.
Qualified Options (ISOs):
Qualified options should typically be exercised through an exercise-and-hold strategy. Unlike nonqualified options, if you exercise and hold the shares for a year, the gain portion of the exercise is taxed at lower capital gains rates. There are also Alternative Minimum Tax implications to qualified options. There are a few scenarios in which it may be best to sell an ISO immediately, but you should consult with a professional prior to doing so.
Nonqualified Options (NSOs):
The value of nonqualified options is taxed at ordinary income rates at the time of exercise.
Factors to Consider
Regardless of the method of exercise, you will be taxed immediately. Choosing between an exercise-and-sell and exercise-and-hold strategy depends largely on the following factors:
- Are more than 20 percent of your investable assets tied up in your company stock? Many people have company stock within their 401(k) in addition to their options. If you have a large concentration of company stock, it may be a good idea to perform an exercise and sell and use the proceeds to increase the diversification of your portfolio.
- Is the company stock value at risk? If your company's expectations are poor and you feel the likelihood they can turn things around is small, you should probably exercise and sell as soon as you can.
- Are your options about to expire? Typically, if your options are within 3 years of expiration, it may be a good time to exercise. If the stock price goes down in the 3 years prior to expiration, there may not be enough time to make up lost value and the options may expire worthless. Whether or not to sell or hold the stock revolves around your view of the stock's potential and your overall level of diversification.
- Could the value tied up in the options be better used elsewhere? If your company's stock has struggled while the overall market has done well, it may be a good idea to exercise options and use the proceeds in higher growth assets.
- Know the rules governing your options. What are the vesting rules? When do they expire? What are the tax considerations? Will you lose the options if you terminate employment? All these answers will influence whether or not options should be exercised.
Stock options have the potential to create significant wealth for many people. Whether or not you have qualified or nonqualified stock options, it is usually prudent to consult with a professional prior to making a decision on exercising options.