Stock options made (sort of ) simple
If you don't understand stock options, you've got a lot of company.
Between 1999 and 2002, nearly one million Americans
let stock options expire -- and almost that many elected not to
participate in company stock option plans at all, according to estimates
from Fidelity Investments. In a recent Fidelity survey, 53 percent
of respondents admitted that either their company stock option plans
are too complicated or they just don't understand how to use them.
"Even people who are professionals in this field
get confused about these things," says Corey Rosen, author
of "The Employee's Guide to Stock Options."
Rosen believes employers bear some of the blame.
"Companies are spending large amounts of money
on these programs," Rosen says, "and they are spending
very, very little effort to make sure people understand them."
But understanding the plan is only part of the issue.
In addition, employees must also research how participating in a
company stock option plan can help or hinder their financial plans
-- and how it can impact their tax returns at the end of the year.
"With real estate it's location, location, location,"
says Ron Brumberg, editor of mystockoptions.com.
"With employee stock plans, it's taxes, taxes, taxes."
Stock options -- now what
Confused by your company's plan? Here's how the average offering
in a typical stock option works:
Your company invites you to purchase a certain number
of shares within a certain time period at a specific price. It's
called a grant and that action gives you the option of buying the
If you say yes, you'll sign some paperwork, but no
money changes hands. However, the company starts the clock on the
"vesting" process. Different companies will set different
vesting periods -- four years is average -- often with a percentage
of the shares vesting each year, says Kaye A. Thomas, author of
"Consider Your Options."
When a share of stock has "vested," it means
that if you purchase it, you will own it in your own name. When
you buy stock, it's known as exercising your options. Depending
on your company's stock option plan -- and how you play the game
-- you may have to pay taxes when you purchase your stock, on your
next return or after you sell your stock. For that reason alone,
it's a great idea to talk to a financial planner or tax consultant
before you make a decision on your company's stock option plan.
"If you're getting options, you want to take
them," says Rosen. "You don't want to say no."
But, he admits, not everyone really can afford to
say yes when it comes to actually exercising those options.
Best bet, Rosen says: If it doesn't cost you anything,
sign up and keep your options open.
What's your type?
When it comes to the regular stock option plans, there are two major
types: incentive stock options and non-qualified stock options.
Here's how they usually work:
Incentive stock option plan: To take advantage
of favorable tax treatment, the plan must conform to federal guidelines,
Baker, author of "The Stock Options Book." It's limited
to company employees only. The options have to expire after 10 years.
And there's no limit to how much you can purchase -- but you can't
exercise more than $100,000 worth of shares (using the grant price)
that become first exercisable in any one year.
You pay for the stock when you exercise your options.
The downside: Depending on the difference in the price you paid
and the value of the shares when you exercised your option -- called
the "spread" -- you might have to pay alternative minimum
tax on your next return.
Alternative minimum tax is a second way of calculating
your income -- and it includes any profit you might have made on
paper from exercising stock options. To find out if you might have
to pay alternative minimum tax, you really need to see a tax adviser.
Or you can avoid paying extra tax -- but not filing paperwork --
by selling the shares in the same calendar year you exercise them
and paying income tax on the gains.
If you're not required to pay alternative minimum
tax, you won't pay tax on your incentive stock options until you
sell them. If you hold them for two years after you were granted
the options and at least one year after you purchased them, they
will qualify as long-term capital gains, which means they'll likely
be taxed at a lower rate than your income. If you get rid of your
shares before then, you will pay ordinary income tax on the spread
-- and any additional amount -- if any -- will be taxed as capital
Non-qualified stock option plan: Since this
plan doesn't have to conform to the same federal guidelines, employers
have a lot more flexibility in designing them. And that means you
really have to ask some extra questions so that you know what happens
in any scenario. The plans are open to non-employees and there are
no federally imposed maximums on the amount of stock you can buy.
While there is no limit on the expiration date, it would be very
unusual to go beyond 10 years, says Thomas.
Just like incentive stock options, you pay for the
stock when you exercise your options. The bad news: You also have
to write a check for income tax on the spread the minute you exercise
your options. The good news: You don't have to worry about alternative
minimum tax. And if you keep the stock for at least one year after
you buy it, the taxman views it as a long-term investment -- just
like a regular stock purchase -- and any profits qualify for the
(usually) lower long-term capital gains rate.
Play 20 questions
If you are thinking about investing in your company's stock option
plan, there are some very basic questions -- and a couple of not-so-basic
ones -- that you'll need to answer. "There's a little bit of
a learning curve here," says John Scott, director of retirement
policy for the American Benefits Council, a nonprofit organization
of large employers that sponsor benefits programs.
First things first: Meet with the plan administrator.
"Find out who this person is, and make sure you
have all of the documents that explain how the program works,"
says Rosen, also the executive director of the National
Center for Employee Ownership, a nonprofit membership organization.
Some questions to start: How much is each share? What
are the conditions for exercising the options? How long is the company
granting you this option? What restrictions are there? If you say
yes -- or take a pass -- how long before you can reconsider? What
are your options if the stock price sinks? What's the stock's track
What are the mechanics of exercising your options?
Nail down exactly how and what you'll be expected to pay. Can you
buy stocks before they vest?
If you quit or are fired, what happens to your options?
And what happens if your company merges or is sold?
And look at the fine print -- especially when it comes
to your tax consequences. "You really want to understand how
it works," says Baker. "Because there are different things
you can do to protect yourself."
Behind closed doors
Once you've gotten all the information you can from your company,
it's time to do some sleuthing -- and soul searching -- on your
own. Do some reading and talk to investors you trust and respect.
When it comes to taxes, beware of one-size-fits-all
advice from Web sites or books, says Rosen. "[Typically,] the
person they have in mind is the executive with $100,000 in value
-- a high-net worth individual.
"But those models aren't well adapted to the
person with $2,000 or $20,000," he says. Two sources that he
does use regularly: mystockoptions.com and mycriticalcapital.com.
At this point, it's a good idea to talk with an independent
professional -- a neutral investment expert who has nothing to do
with your company and nothing to gain from your decision -- to see
if this stock option plan is the best option for you.
"You really want someone looking out for your
particular situation and judging it in the context of your overall
financial plan," says Scott.
Find out under what circumstances you might have to
pay alternative minimum tax. What happens if you buy the stock at
a bargain discount, but the price sinks? In a worst-case scenario,
you could be left holding a large tax bill for paper profits on
stocks that are worth much less in real life.
And how would the investment fit your existing financial
and life plans? Some things to consider: Have you already salted
away a few months' salary for emergencies? Are you planning to change
jobs in the next few years? How solid is your company? How close
is retirement? Do you have enough to cover other life events --
such as kids in college, aging parents and medical emergencies?
And there's the investment itself: Have you got the
cash on hand to cover taxes on your stocks -- or would you need
to sell shares to cover it? How much can you afford to risk? And
are you comfortable with the risks?
"Nobody should assume -- no matter how good a
company is -- that you can predict what would happen to company
stock," says Thomas.
You also want to look at diversification. If your
company is using its own stock to back your 401(k) account, do you
want to invest more money in essentially the same place?
"You're putting all your eggs in one basket,"
says Amy Jantz, senior compensation manager at WorldatWork, a global
nonprofit association for compensation and benefit professionals.
"That's probably not a good thing to do,"
If your paycheck and health benefits come from the
same place you're investing in a 401(k) and amassing stock, what
happens to you if something happens to the company?
Come April 15 ...
And then there are taxes.
"You should be very clear about what the tax
consequences are," says Rosen. "And for a lot of people
it's going to be daunting."
For instance, the minute you exercise an option for
an incentive stock option plan, you have committed yourself to doing
your income tax twice -- using two different sets of calculations,
says Baker. You pay based on the higher amount. But just because
you have to do the math doesn't mean you'll automatically owe more
The good news for stock option investors: You likely
have some choices. The bad news: It's up to you to get informed
and make the right decisions. "You need to know what those
risks are," Rosen says.
But many people are unprepared, he says.
As with any other stock investment, there is also
the issue of trust. How strong is your company stock and how much
do you trust your company not just to give you a paycheck but also
to manage your investment?
"It's much like putting money in a 401(k) and
investing in the stock market," says Scott. "A return
is not guaranteed. You have to get over, not only the mechanics,
but the idea of risk."
And you also have to look at the financial "big
"It may look like free money," says Baker,
"but you have to look at it with the same critical eye as any
Dana Dratch is a freelance
writer based in Atlanta.
-- Posted: May 20, 2004