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Planning Your Retirement Using Stock Options

For many executives, stock options are a significant part of compensation—and a major wild card when planning for retirement. Handled well, stock options can provide a significant boost to your nest egg. Yet options are complex, and it’s easy to squander investment opportunities, increase tax liability, and just generally dilute options’ values. These suggestions could help you make the most of this important employee perk.

Know your type. Stock options come in two varieties: incentive stock options (ISOs) and nonqualified stock options (NQSOs). Each has a different tax treatment, which can influence your decisions about when to exercise your options and when to sell the stock you receive.

ISOs get special tax treatment. After you exercise your options, as long as you hold your stock until at least two years after your options were granted and at least one year after you bought the shares as part of exercising the option, your entire profit will be considered a capital gain, and you’ll be taxed at the current 15% long-term capital gains rate. Sell sooner than that, however, and some or all of your gain may be considered ordinary income, subject to a much higher tax rate. But in either case, you’re taxed only when you sell. Plans differ, but ISOs usually have to be exercised within three months of the date you leave a company. Also, depending on how long you hold your stock after exercise, you could be subject to alternative minimum tax, though you may be able to limit AMT exposure by staggering stock sales or other strategies. Note: In light of the recent stock market decline, a 2008 tax law abates AMT liability stemming from the exercise of ISOs before 2008. Consult with a tax professional for more details.

NQSOs are handled differently. With these options, the difference between the exercise price and market price of shares at the time you exercise is taxed as income for that year. Then, when you sell your stock, any additional profit—beyond the market price when you bought the shares—is taxed as either a short- or long-term capital gain, depending on whether you held the stock for at least a year.

Understand what your options are really worth. Though taxes can erode the apparent value of your options, calculating your liability is as involved as it is essential. Suppose you have NQSOs that let you buy 1,000 shares of your company’s stock at an exercise price of $75. The stock is now trading at $100. The real value of those options? If you exercise, you’ll have $100,000 invested in company stock. But you had to come up with $75,000 to buy the shares, and your $25,000 discount will be subject to as much as 40% in combined federal and state income tax, depending on your personal tax bracket in the year of the exercise. So your net benefit might be as little as $15,000.

Worse, the extra income could nudge you into a higher tax bracket. For this example, suppose it’s near the end of the year and your taxable income is about $150,000. If you exercise your NQSOs, you might add another $100,000 in income for the year—and find yourself paying 33% rather than 28% on that part of your income. In 2009, the 33% bracket begins at $208,850, for a married couple filing jointly, so you’d owe 33% on the next $41,150. To avoid that extra five percentage point hit, you may decide to delay exercising a portion of the option—those taxed at the 33% rate. However, taxes are only one of several considerations when managing your options.

Don’t overdose on company stock. The larger the spread between exercise and market prices, the bigger your profit. So if you’re bullish on your company’s prospects, holding on to your options could translate to greater returns down the road. But if company stock already accounts for 10% or more of your portfolio, it may be better to exercise now and sell some shares to diversify into other investments.

A more aggressive strategy allows you to diversify your portfolio and keep your shares. You could use the stock from your option grant as collateral and buy broader holdings on margin. If your company’s growth continues as expected, the returns from the stock can outweigh the cost of the margin loan. But if your company’s shares falter, you run the risk of margin calls and a forced sale.


This article was written by a professional financial journalist for Legend Financial Advisors, Inc. and is not intended as legal or investment advice.

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