Stock Option Awards: What to Consider

Ken Weingarten |
Categories
Investment Planning
Tax Planning
Asset Allocation

In our previous blog, we discussed considerations when compensated with restricted stock. Another major form of compensation that many individuals are awarded are stock options. While there are some similarities between options and restricted stock awards, this form of compensation has its own set of rules and planning opportunities. Below we go over some of the major points to think about when faced with this type of compensation:

The Type of Stock Option

There are two types of stock option awards: Nonqualified Stock Options (NQSO) and Incentive Stock Options (ISO). Both share similarities in that they give the employee the option to buy a specified number of company shares at a strike price. Typically, there is a time window of several years to exercise the option. While the process is the same for both, the main difference between NQSOs and ISOs is the favorable tax treatment of ISOs when the option is exercised. Below is simple chart comparing the differences:

Tax Planning – ISOs vs NQSOs

In order for an ISO to receive favorable tax treatment, the underlying shares must meet the following qualifications:

  • The stock must be sold at least two years after the option’s grant date.
  • Once the option is exercised, the shares must be owned for at least one year.
  • There is a $100,000 limit on aggregate value of ISOs that are exercise in any calendar year.

Failing to meet these qualifications will disqualify the ISO’s tax treatment and revert it to a NQSO status. Below is an illustration comparing the differences of each type at various stages:

 

Diversification

Due to the longer holding period requirement of ISOs, factoring in the exercised shares into your overall allocation presents an issue. While the tax savings are important, the potential volatility over the course of the two-year minimum holding period can affect your portfolio’s expected rate of return. Planning for this holding period and understanding when you are able to sell the stock for the sake of your overall allocation’s risk is crucial to maintain proper diversification.

Goals

Just like with restricted stock, you may intend to use stock options and their subsequent proceeds to fund financial goals. Your situation may get a bit more complicated if you are awarded with a blend of restricted stock and stock options. Mapping out the years ahead and aligning them with your goals, via a financial plan, can clearly line up your expectations for the future.

 

Conclusion

Regardless of whether you have received ISOs, NQSOs, or Restricted Stock, you should be aware of the major component that they all share in common: Taxes. Beyond this, there are investment planning, cash flow planning, and potential estate planning opportunities to consider. In-depth planning is strongly recommended to get the most of out of these awards. Consulting with a fee-only financial advisor can help you address this complex field.

Weingarten Associates is an independent, fee-only Registered Investment Advisor in Lawrenceville, New Jersey serving Princeton, NJ as well as the Greater Mercer County/Bucks County region. We make a difference in the lives of our clients by providing them with exceptional financial planning, investment management, and tax advice.