Capturing the potential of your employee stock options

Key Points

• Capturing the Potential of Your Employee Stock Options
• What Is an Employee Stock Option?
• Your Options With Options
• Exercise Strategies at a Glance
• Stock Options and Your Financial Plan
• Let Ameriprise Financial Help Plan Your Future
• Points to Remember

Capturing the Potential of Your Employee Stock Options

The economic boom of the 1990s certainly benefited businesses of all shapes and sizes. But with that success came a price: Businesses needed to beef up compensation and benefit packages to attract and retain the best employees. As a result, employee stock options — once the providence of only the most highly compensated executives — have found their way into have the benefits packages of a much larger number of talented workers.

If you've been fortunate to receive employee stock options, it's important to understand that the planning issues surrounding this benefit can be complex because the decisions you make can affect your financial future in so many ways. That's why professional assistance is a must. The Personal Advisors of Ameriprise Financial have the experience to assist you in making informed decisions about exercising (i.e., purchasing shares) or transferring your stock options.

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What Is an Employee Stock Option?

In short, a stock option is a contract that allows you the right to purchase a set number of shares of company stock at a specific price for a certain period of time. The adage "timing is everything" is especially appropriate for employee stock options. Although deciding what to do with stock options is complicated, one of the worst risks you can take is not to explore your planning options. Why? If you exercise your options without careful consideration, you could potentially subject yourself to unexpected — and significant — tax consequences. On the other hand, if you don't exercise your options by a certain time, as specified in the contract, they will expire.

Typically, the value of your stock options may be measured in two ways: current and future value. If the stock is currently trading at $44 per share and your option entitles you to purchase it at $30 per share, its current worth to you is $14 ($44 minus $30). Of course, that doesn't include taxes or transaction fees. Even if your options have an exercise price that's more than the current price at which the stock trades, it still has potential value. That's because your options may increase in value over time. Remember, you have until the date that your contract expires to exercise your options — a date that may be years away.

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Your Options With Options

It's important to know which type of stock option — nonqualified stock options (NQSOs) or incentive stock options (ISOs) — you hold so that you can develop an appropriate strategy for getting the most value from your options. What's the difference? Primarily the way in which they're taxed once you decide to exercise your options.

Many people receive NQSOs, for which the holder is taxed on the difference between the option price and the market value of when it is exercised (the bargain element). If you own this type of stock option, exercising your option creates taxable income — it is considered compensation and will trigger income taxes. If you're in the highest federal income tax bracket, your tax rate could be as high as 35%.¹ Then, when you ultimately sell the stock, you'll pay either short- or long-term capital gains tax — depending on how long you hold the stock — on any additional price appreciation.

ISOs, on the other hand, are generally not subject to regular income tax when the options are exercised. However, when ISOs are exercised, the federal alternative minimum tax (AMT) could come into play, especially if the stock has substantially appreciated in value. The AMT would be paid in addition to any regular income tax.

The AMT was implemented to ensure that wealthy individuals pay a certain amount of tax even if they have substantial tax deductions, credits, and exemptions. However, more and more individuals find themselves exposed to the AMT, and exercising ISOs can most certainly increase the likelihood that the AMT will apply.

In addition, if the ISO holder keeps the shares at least one year after the exercise date and two years from the date the options were granted, the sale of the shares will be taxed at the lower long-term capital gains rates of either 10% or 15%. Carefully planning the exercise and sale of ISOs can limit an individual's exposure to the AMT.

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Exercise Strategies at a Glance

There are two primary considerations when choosing an exercise strategy: (1) improving equity position by reducing taxes, and (2) managing investment risk. The following exercise strategies may help achieve either or both objectives under the appropriate circumstances.

Exercise and hold: Using this strategy will impact your current cash flow. If you hold NQSOs, you'll not only have to buy the stock but also pay the income tax due. However, you'll begin receiving dividends paid on the stock. It also begins the holding period for a more preferential capital gains tax rate when you choose to sell the stock.

Exercise and sell: If you're holding options in a stock that's experiencing a long-term decline in value, you may want to consider this strategy. You'll have to pay ordinary income taxes rather than preferential rates that may be available if you held onto the stock. Of course, if the stock increases in value after you've sold it, you've lost out on any future growth.

Hold and exercise prior to expiration: If you hold NQSOs, you may benefit from this strategy because it delays payment of taxes. You'll have to weigh the current value of the stock options versus the potential for future appreciation.

Exercise some stock options each year: If you hold ISOs, you may be less likely to trigger the AMT with this approach. In addition, if you hold the stock for at least 12 months, you will qualify for favorable long-term capital gains treatment.

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Stock Options and Your Financial Plan

Exercising employee stock options represents a significant opportunity for wealth creation. However, this action requires careful planning because it can affect so many of your long-term financial objectives and your short-term cash flow. There are a number of exercise strategies that you can employ — each with different tax consequences. The strategy that you choose to use will depend on your individual situation.

To understand the full scope of the potential impact that employee stock options may have on a financial plan, consider the following hypothetical example. Michael Smith has NQSO and ISO stock options (worth in the high six-figure range) granted by the computer company where he works. He and his wife Karen want to use the options to generate income for their two children's college education and their own retirement. Wealth preservation for future generations is also a priority. Other goals: to exercise the options with a minimum of taxes and to diversify their portfolio. Here are some questions that the couple should consider prior to exercising options.

1. Do the Smiths have enough cash or liquid assets to exercise the options and to pay any resulting taxes?
2. What percentage of their portfolio should they leave in the employer's stock?
3. What's the best way to exercise the options to reduce taxes while investing for their children's education and their own retirement?
4. What happens to unexercised options in the event of Michael's death?

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Let Ameriprise Financial Help Plan Your Future

Employee stock options can be a mixed blessing. Although a tremendous benefit to receive, they are one of the most complicated forms of compensation. How you choose to use your options can affect your financial goals (plan) — both short-term and well into the future. Because there are so many issues to take into consideration and many different exercise strategies from which to choose, careful planning is crucial to helping you receive the most value from your options.

Ameriprise Financial can help. Our specially trained financial advisors can help you make an informed decision about your stock options. We'll work with you to create a personalized strategy that takes into account your entire financial plan. At Ameriprise Financial, our goal is simple: To help ensure that the reward for your hard work today results in achievement of your investment goals tomorrow.

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Points to Remember

1. A stock option is a contract that allows purchase of a set number of shares of company stock at a specific price for a certain period of time.
2. Options have both current and potential future value. Current worth is determined by the extent of the exercise price below current market value of the stock. Future value is determined by the potential to increase in value until such time as your options must be exercised before they expire.
3. There are two types of employee stock options and each type has different tax consequences. Holders of nonqualified stock options (NQSOs) pay federal income tax on the profit they earn when the options are bought (or exercised). Holders of incentive stock options (ISOs) are taxed when sold and may trigger the alternative minimum tax.
4. The exercise strategy that is employed is dependent upon a person's individual circumstances and his or her financial goals, risk tolerance, and time horizon.
5. Because employee stock options are complicated and can affect all aspects of your financial plan, it's wise to work with a financial professional before exercising them.

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¹Effective 2003, the top federal income tax rate was reduced to 35%.

Financial planning services and investments offered through Ameriprise Financial Services, Inc., Member FINRA and SIPC.

There are risks associated with fixed income investments, including credit risk, interest rate risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities. Non-investment grade securities, commonly called "high-yield" or "junk" bonds, generally have more volatile prices and carry more risk to principal and income than investment grade securities.