(originally written by Liz Davidson)
Do you have stock options or shares of your employer’s stock? If you’re like many of the employees we help, you may not know what to do with them or even what the alphabet soup of incentive stock plans are (SARs, RSUs, etc). Used the right way, incentive stock plans can be a great addition to your compensation and retirement portfolio. They’re often a “hidden” asset that employees can use to build an emergency fund, pay down debt, or contribute to an IRA. But used incorrectly, they can also increase your risk or expose you to a nasty surprise come tax time. Here are some guidelines to consider:
have an emergency fund?
If you don’t have enough cash reserves to cover at least 3-6 months’ worth of necessary expenses, this should be your priority. If something were to happen to your company, you could find yourself out of a job at the same time that your employer stock and options could be worthless. If you have vested stock options, consider exercising them. If you have shares of employer stock that you can sell, consider doing so. Use the proceeds to build up your emergency fund.
have high interest debt?
If the interest on your debt exceeds what you’re likely to earn from your employer stock (5-7% is a reasonable estimate), you may want to sell the shares and put the proceeds towards the debt.
match the max in your 401(k)?
It’s unlikely that your employer stock purchase discount is as valuable as your match so contribute at least enough to your retirement plan to max that match before purchasing employer stock.
have too much in company stock?
As a general rule, no stock should be more than 10-15% of your portfolio.This is especially true of your employer’s stock since your job is already tied to that company. You’ll also want to include it as part of the stock allocation of your overall portfolio. In either case, sell at least enough shares or exercise enough options to bring your exposure to a reasonable level and reinvest the money in something more diversified.
have access to an employee stock purchase plan?
As long as you’ve got the last four bases covered, you may want to take advantage of any discounts offered on purchasing company stock. You can always sell the stock later and reinvest the proceeds or use it to fund IRA contributions.
own shares that have gone down in value?
By selling the shares, you may be eligible to use the losses to offset gains and other income, including up to $3k in ordinary income. (Net losses in excess of $3k can be carried forward indefinitely).
own appreciated stock that you’ve had for less than a year?
If so, you may want to hold onto them until that one year mark before selling them. That’s because you can then qualify for a lower capital gains tax rate on the gains. Otherwise, you’ll end up having to pay higher ordinary income tax rates.
want to pay taxes on the proceeds now or later?
Before exercising options or selling shares, it’s important to understand how they’re taxed. For example, when you exercise stock appreciation rights (SARs), you’re essentially getting a cash payout based on how much the stock has appreciated over a given time period, and like other cash payments from your employer, you have to pay ordinary income taxes on the proceeds. Likewise, when you exercise non-qualified stock options, which give you the right to purchase shares at a given “strike price,” you have to pay ordinary income taxes on the spread between the fair market value of the stock and the option’s strike price. If this will push you into a higher tax bracket, you may want to exercise them over more than one year. If you expect your tax bracket to be lower next year, you may also want to wait and exercise them then.
While exercising incentive stock options (ISOs) does not create an immediate tax liability, the spread between the fair market value of the stock and the option’s strike price could be included as income under the Alternative Minimum Tax (AMT). (You can learn more about how ISOs are taxed here.) If this could make you subject to the ATM or increase your AMT liability, you may want to wait until a future year to exercise them.
have appreciated company stock in your employer’s retirement plan?
When you leave the company, you can roll the shares out of your retirement plan and pay a lower capital gains tax rate on the gain (assuming you’ve held the shares for at least 12 months). However, you lose that benefit if you sell the shares within the retirement account or roll them into an IRA. That could be a reason to delay selling the stock if you’re getting close to leaving the company.
As with most financial planning, the first step in taking advantage of your incentive stock plans is to start with your goals and how they might help you achieve them. Then whether you decide to exercise your options and sell your stock or purchase more shares through an employer stock purchase plan, you need to know how they fit into your investment portfolio and how they can be managed to minimize taxes. After all, knowing is half the battle.