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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 "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:

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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 stock.

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, says Alisa 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 gains.

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 record?

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: and

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," she says.

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 tax.

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 picture."

"It may look like free money," says Baker, "but you have to look at it with the same critical eye as any investment."

Dana Dratch is a freelance writer based in Atlanta.


-- Posted: May 20, 2004

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