While receiving stock options as part of an overall compensation package is generally perceived as a benefit available only to wealthy executives, a number of companies offer stock options to employees throughout their organizations. As you saw in the first part of this article, stock options can be beneficial to both employees and their employers. In determining the best way to use your options, however, you have to understand the way they're treated for tax purposes. Once you get the gist of how stock options work, you can then turn to the question of how to integrate them into your financial plan.
Diversification risk
The most significant risk to employees who receive stock options as a substantial part of their compensation is that their financial plan suffers from a lack of diversification. Unless you have significant assets that generate investment income, you probably get the vast majority of your income from your job. You're therefore relying on the continued success of your employer to be able to keep paying you. On the other hand, if you receive a large grant of stock options, then a big fraction of your investment portfolio may wind up being shares of your employer's stock. That situation can leave you extremely vulnerable if your employer suffers a major setback.
In the most extreme example, you could lose not only your job but also much of your portfolio's value if your employer suddenly went out of business. Just as many employees at Enron suffered doubly from that company's collapse -- they were no longer receiving salaries, and the company shares in their retirement accounts became worthless -- large holdings in stock options make it difficult for you to diversify your portfolio to reduce your risk.
Not all financial planners agree that a concentration of employer stock in your portfolio is necessarily a bad thing. You probably understand your own employer better than any other company whose stock you own, so you may make better-informed decisions about your employer's stock. However, if your job doesn't give you information about everything your employer does, then the partial picture you have of your company's financial situation may be misleading. The typical advice you'll receive is to take opportunities to broaden your portfolio when they arise.
Benefits of early exercise
With options that trade on public exchanges, it rarely makes sense to exercise before you have to. Usually, you can get more money by selling the option than you would by exercising it. However, you typically can't sell employee stock options. Often, exercising your options early may be your best bet, for several reasons. First, holding stock options gives you more leverage than owning employer stock outright, and the value of your options is more sensitive to price movements in your employer's stock. For instance, if you are granted options to buy company stock for $40 and the price rises to $50, then your options are worth $10. However, if the stock price subsequently falls back to $45, shareholders would suffer only a 10% loss, while the value of your options would fall by 50%. Exercising some of your options reduces your leverage and adds stability to your investment.
In addition, exercising shares early can help you manage your tax liability. If your options create tax liability when you exercise them, waiting until the last possible moment to exercise all of your options can add huge amounts of taxable income to your return and potentially put you into a much higher tax bracket, where you may suffer from an expensive tax bill. By exercising a portion of your options over a number of years, you make it less likely that you'll have a windfall resulting in higher taxes.
Consider gifts
Some stock-option plans allow participants to make gifts of their options to family members, either outright or in trust. Making gifts of your options may allow you to reduce the amount of income tax you have to pay when you exercise your options or sell the stock you get from exercising them, if the person who receives the options pays taxes at a lower rate. Furthermore, if you're facing potential estate tax liability, using options to make gifts can allow you to transfer a large amount of wealth to future generations at little or no cost. For instance, if you give away your options right after you get them, then their value will be relatively small, so you won't have to pay much in gift taxes. Once you no longer own the options, then any future appreciation belongs to the person you gave them to, and so if the options perform well, then you'll have potentially saved yourself from a larger estate tax bill.
Planning with stock options is extremely complicated, and you should consult with your accountant or tax attorney to help you come up with the best plan for your particular situation. With the right help, however, you can make sure you get as much value from your stock options as possible. After all, you've worked hard to earn your options, and you deserve every penny your options pay you.
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Fool contributor Dan Caplinger has never had the good fortune of getting stock options at work. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy doesn't backdate on you.
