Beware of Taxes When Exercising Stock Options

Every Tuesday

Stock options, once the province of the corner-office crowd, are becoming as common as paid vacations at many companies. Midlevel workers are going home at night with a fistful of stock options and a head full of dreams.

But before you get carried away and start planning your next vacation, it’s important to understand how your stock options work. Stock options can boost your income, but they also can inflate your tax bill. Worse, mishandled options can become worthless, which is probably how you’ll feel if you let that happen.

There are two types of employee stock options: incentive, which are generally awarded to senior executives, and non-qualified, which are awarded to everybody else. This column focuses on the latter.

A non-qualified option gives you the right to buy a set number of shares of your employer’s stock at a specific price, known as the grant price, during a specified period of time. Buying the shares at the grant price is known as exercising the option. Your profit is the difference between the grant price and the stock’s market price when you exercise. For example, if you have an option to buy 1,000 shares of your company’s stock for $1 a share, and exercise your option when the stock is selling at $5 a share, your profit is $4,000. The down side: If the stock price falls below $1 a share, your option is worthless.

Typically, you can’t exercise right away and must wait until options are vested, which can take one to five years. Options also have an expiration date. If you don’t exercise before then, your option is worthless. So you have to exercise somewhere between the option’s vesting and expiration dates.

Non-qualified stock options usually aren’t taxed until you exercise them, says William Newell, president of Atlantic Capital Management in Sherborn, Mass. But once you exercise your option, you’ll be taxed on the difference between the grant price and the stock’s market price, at your ordinary income tax rate. You might also owe Social Security taxes and state taxes on your gain.

Many workers exercise their options, then immediately sell the stock, limiting taxes to the difference between the exercise price and the market value. But suppose you exercise your option and keep your shares. You’ll still owe taxes on the difference between the grant price and the stock price on the day you exercised. And if the price of the shares continues to rise, you’ll be taxed again when you sell, this time on the difference between the price on the day you exercised your option and the price on the day you sell your shares.

Using the above example, if you exercise an option to buy 1,000 shares for $5 a share and sell them a year later for $10 a share, you’ll owe capital gains taxes on $5,000. That’s on top of the income tax when you exercised the option.

So why would you hold on to your stock after exercising an option? Because in some instances, that strategy can reduce your overall tax hit. Suppose you have three years after you’re vested to exercise. If you wait until the end of that period, the entire difference between your grant price and the stock’s price when you exercise will be taxed at your ordinary income rate. It could even nudge you into a higher tax bracket.

But let’s suppose you exercise your option a year after you’re vested, but hold on to the stock. The difference between your grant price and the stock’s fair market value won’t be as large, meaning a smaller amount will be taxed at your income tax rate. If you hold the stock for at least a year and it continues to rise, any additional gains will be taxed at the lower capital gains rate — 20% for most investors.

Other factors to consider when deciding when to exercise:

* Your tax status. If you believe your income tax rate will fall in a particular year — you’re planning to retire, for example — it might make sense to wait and exercise your options that year, says David Yeske, a financial planner in San Francisco. Similarly, you may want to avoid exercising options in years in which you expect to receive a big bonus.

* Diversification. If half your portfolio is already made up of company stock, unexercised stock options can make you even more dependent on your company’s fortunes. If the company falls on tough times, your salary and the value of your stock options could disappear. A more sensible plan: Exercise some options, sell the stock and use the cash to diversify your portfolio into other investments.

Questions? Write: Your Money, 1000 Wilson Blvd., Arlington, Va. 22229. Or email: sblock@usatoday.com

TEXT WITHIN GRAPHIC BEGINS HERE

What are my options?

Average lowest salary for employees eligible for stock options:

1996 $58,500 1997 $64,200 1998 $70,900 1999 $58,100

Percent of employees eligible for stock option grants:

1996 12% 1997 15% 1998 12% 1999 19%