Managing Your Stock Options

Portfolio Planning Article

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Managing Your Stock Options
by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
May 25, 2004

Like any other investment, stock options must be managed to maximize their potential value. Before exercising options, you need to understand the role you want them to play in your overall financial strategy.

Here are some factors to consider:

How do your stock options fit into your investment portfolio?
What are your short-term and long-term goals?
When should you exercise options?

Let's look at each of these in turn.

Stock options and your portfolio
Because stock options give you the right to purchase shares of your employer's stock, you first need to decide how much of your portfolio will be composed of stocks in general and your employer’s stock in particular.

Many factors go into deciding how much stock you should hold, including your investment goals, tolerance for risk, the importance of balance in your portfolio, the current market price of your employer's stock and its potential for increase or decrease, and the strength of your employer’s business.

Figure out how much of your employer's stock you already hold in your portfolio, including any 401(k) and stock purchase plan investments. To complete the picture, look at any vested stock options you hold and add the in-the-money value—that is, the spread, or difference between your exercise price and the current price of the stock.

If the value of your company stock approaches 20% or more of your total equity exposure, you may want to implement a diversification plan.

Stock options and your goals
As with any sound portfolio strategy, implementing a program to exercise stock options begins with identifying your short-term and long-term financial goals.

Do you need cash now for a major expense? Do you have to make a large cash outlay in the next three to five years? Look at big, long-term goals such as buying a house, paying for a child's education and financing your retirement. For each major goal, calculate how much money you'll need within what time frame. Then develop an investment plan to help you reach these goals and decide what role, if any, you want your stock options to play.

Stock options and timing
Because stock options have a limited life, the timing of your exercise is an important part of managing your options. Generally, you must hold options for a period of time before exercising them. This is called vesting. If your options from a particular grant vest at the rate of 25% per year over four years, you can exercise 25% of those options after one year. All of the options in this grant will be vested after four years. Most option grants give you up to 10 years from the date of grant to exercise your options before they expire.

When deciding to exercise sooner vs. later, consider the stock's potential. If you think the stock price will stay flat or decrease, you might want to exercise sooner. If you think the stock price will increase, you may want to postpone exercising.

Assuming your company stock goes up in the long term, it's generally better to exercise later. Exercising early represents an opportunity cost: The money you need to put up for the exercise price and any taxes due could be working elsewhere. Meanwhile, your options could be growing essentially tax deferred.

One strategy is to wait until at least half-way through the life of your grant. You can then exercise a portion of your options each year, averaging out of your position. That way you don't sacrifice potential tax-deferred growth by exercising too early, nor do you paint yourself into a corner by waiting until just before your options expire, when you'll have far less flexibility.

Taxes play a role in your timing as well.

If you exercise incentive stock options (ISOs), you must hold the shares for two years from the grant date and one year from the exercise date in order to receive favorable tax treatment.
If you exercise ISOs, you may trigger alternative minimum tax. AMT could increase the amount of tax you owe in the year of exercise, which means you may have to pay estimated income taxes to avoid underpayment penalties. You may also have estimated-tax issues with non-qualified stock options (NQSOs), even though they’re subject to withholding (see below).
If you disqualify ISOs by not meeting the holding period requirements or if you exercise NQSOs, you must pay ordinary income tax (plus FICA taxes for NQSOs) on the spread in the year of exercise (or in the year of the disqualifying disposition in the case of ISOs). You either need the cash to pay the exercise costs, transaction fees and additional taxes, or you need to sell enough shares to cover these expenses. It's a good idea to consult your tax advisor or financial planner prior to any exercise so you'll be adequately prepared to handle the cash flows, which include meeting your tax obligations.

The bottom line
Employee stock options can be a valuable benefit. But deciding when to exercise your options can be complex. The wrong decision can cost you money, while the right decision can put money in your pocket or increase the value of your portfolio.

Be sure to get expert help if you need it. A Schwab Equity Compensation Consultation is a good place to start.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment or tax advice. Each investor needs to review a security transaction for his or her own particular situation. Data contained here is obtained from what are considered reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed.

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