Understand your employee stock plan
Daniel Jimenez • Bankrate.com

You've probably heard stories about workers getting filthy rich from their employer's stock compensation programs. There's no question that many employees have hit the mother lode by owning a piece of their company. But there's more to it than just sitting back and waiting to collect your fortune. Participating in employee stock ownership and stock option plans also means that you'll eventually have to make some big decisions regarding your financial future.

Stock plan terminology

You won't be able to make an educated financial plan if you don't understand your employee benefits first. Unfortunately, a great deal of confusion exists in this area. A new study by the International Association for Financial Planning found that 66 percent of financial planners believe that most stock-plan participants don't fully understand the risks involved.

"It is a very confusing topic," says Ryan Weeden, project director for the Oakland, Calif.-based National Center for Employee Ownership. "We've had situations when an executive was being given 500,000 options by the company, and he's said 'I can't pay this money.' I'm talking about senior executives at "Fortune 500" companies. If they don't understand this, then how is someone who works a regular job at a manufacturing plant and who gets 100 shares of company stock supposed to understand it?"

Part of the confusion is related to the similar names used by the two main types of stock compensation programs. Here's how the NCEO defines those programs:

• "An employee stock ownership plan is a retirement-type plan in which a trust holds stock in the employee-participants' names; after they leave (whether due to quitting, retirement, etc.), they cash in on the proceeds due them."

• "An employee stock option plan gives an employee the right to buy a given amount of company stock for a given period. Employees do not hold the stock until they "exercise" the options and buy it -- whereupon they frequently sell the stock immediately to cash in on its rise in value above the price they paid for it."

Both of these types of plans offer great advantages, but there are some important differences between the two that you should know about. ESOPs usually cover all full-time adult employees. Also, the employer (not the employee) makes yearly contributions of company stock and/or cash to buy stock.

Stock option plans are not retirement plans, and they also differ from ESOPs in that the plan is designed for the employees to buy the stock and hold it directly. Unlike ESOPs, the company decides which employees get offered stock options. If you remember just one thing from reading this article, then please hang on to this thought: Employee stock option plans are never referred to as ESOPs!

Stock plans are as simple as brain surgery

Once you know the ABCs of the company's ESOPs and stock options, the next step is to identify the potential trouble areas of these plans. One of the key issues deals with how heavily you rely on your company's stock to fund your retirement. Lydia P. Sheckels, a financial planner for Wescott Financial Planning in Philadelphia, suggests that employees diversify their investments using tools such as a 401(k) plan.

"Most people who have most of their net worth in company stock have seen the stock value rise in the past few years," says Sheckels. "They begin to assume that their company stock will always go up. They don't think about the impact on their net worth if the stock were to go down. ... They wake up one day and sometimes they're lucky if they have a savings account or a money market account."

"If you're looking at stock options as a primary source of retirement funds, then that is a risky venture," agrees Weeden.

Another major issue concerning stock plans relates to tax planning matters. Stock option taxes vary depending on the sort of plan that your employer uses. Tax-qualified options (incentive stock options or ISOs) allow you to defer paying taxes until after you've sold your options. The ISOs also let you pay at the capital gains tax rate of 20 percent instead of the ordinary income tax rate, as long as you hold your options for at least 12 months. With non-qualified options (NSOs), you are taxed on any capital gains as soon as you exercise that option, even though you may not have sold these options yet.

Employees would much rather get ISOs, but these options carry some tax hazards in the form of the Alternative Minimum Tax, which kicks in if you pass a certain income threshold. The IRS is going to get you one way or another, folks.

Besides taxes, you also need to be concerned about how long to hold your company stock. The timing will depend largely on what restrictions are included in the terms of your options, your age and your risk tolerance. However, Sheckles warns that the market may not be kind to those who wait too long to exercise their options.

"Not all company stocks are equally liquid," says Sheckles. "If you have stock options with IBM, those are much more liquid than XYZ Company. Some companies don't have as many share buyers out there, so you may be dealing with a thinly traded issue. ... Employees may want to sell their options over a period rather than try to cash out in one day."

Insider trading takes on a whole new meaning in prison

Insider trading violations are another potential problem that shouldn't be overlooked by employee-owners. A trade is considered illegal when someone buys or sells company securities while having material information not available to the public. The Securities and Exchange Commission recently charged an IBM secretary who had tipped off her husband regarding the company's plans to take over another firm, leading 25 people to pocket more than $1.3 million from insider trading.

"It is not just executives who get nailed on these things," says the NCEO's Weeden. "I've heard of the SEC going after people for just a few hundred dollars."

Diversification, taxation, insider trading ... the list of plan considerations goes on, and we haven't even discussed estate planning! Stock compensation experts lament that many people wait too long before they make some of these decisions. That is why it's important that you review your financial situation on a yearly basis. Read all relevant plan documents no matter how boring they appear.

Finally, you may also want to consider consulting with a professional who can explain how to best take advantage of investment and tax planning opportunities related to your stock ownership plan. You can visit the NCEO Web site for more information, or call the IAFP at (888) 806-7526 for a list of planners in your area.

-- Posted: June 4, 1999