Questions you can ask your UBS Financial Advisor
- Should I exercise my employee stock options sooner rather than later?
- How can my options fit into my longer-term financial plans?
Today, many companies use employee stock options to attract and/or retain top talent within their workforce. Like other stock compensation, options have the potential to improve an employee's overall net worth and can be used to help fund short-and long-term financial goals.
But understanding the ins and outs of employee stock options can be a challenge. Here's what you should know.
What are employee stock options?
With employee stock options, your company is giving you the opportunity to buy shares of your company's stock at a predetermined price within a set period of time.
There are a handful of key terms to keep in mind with employee stock options. The first is the price at which you can buy the stock, called the exercise price, strike price, and/or grant price). The ultimate value of your stock options depends on the difference between the grant price and the stock's current market value at time of exercise (post vest date). If the stock price rises above the grant price, your options are considered "in the money" and you can make money by exercising them—less taxes and fees. However, if it falls below the grant price, your options are considered "out of the money" and no profit can be obtained by exercising them; however, assuming no changes to your employment status, you will likely have until your options expiration date (typically 10 years) to exercise them. If at some point during that timeframe the stock price appreciates above the grant price, you can excise for a profit then.
The vesting date is the date when you are eligible to exercise your stock options, and the expiration date is the date at which your options can no longer be exercised. Once the expiration date passes, you forfeit the ability to exercise your options (pending any special circumstances).
That's the easy part. Where things can get more complicated is understanding the nuances of employee stock options in order to maximize their potential value towards your financial goals. Below are some important considerations when it comes time to decide if—or when—to exercise your employee stock options.
Think about short- and long-term financial planning
When it comes to thinking about your long- and short-term goals, Pat McGrady, Director, Head of Employee Education and Advice, UBS Workplace Wealth Services, says it's important to understand that employee stock options, unlike many other potential investments, have a shelf life.
There are advantages to employee stock options that other investment vehicles don’t offer. (a stocks option is not a type of stock – options are a leveraged investment vehicle). For example, most employee stock options' allow the recipient up to 10 years to exercise their option; meaning, an employee may choose to exercise their option if it's "in the money" on its vest date, or if s/he believes the company's future outlook is bright and the stock will continue to rise, s/he can choose to hold onto the options and exercise at a later date (prior to expiration).
Another consideration that McGrady highlights is understanding the associated risks that come with that extra shelf life. Since the stock options are time dependent, there is always the potential for the stock to rise or fall with company performance. So, you might feel more comfortable taking some of the risk off the table by exercising earlier, as opposed to waiting it out the market.
Also, it's important to understand the various ways your company allows you to exercise your stock options. You might have the choice to fully liquidate your options up front, netting cash if "in the money." If you are looking for short-term cash flow—for a down payment on a house, for instance—this path can be an attractive solution.
As you prepare your strategy, keep your long-term goals and short-term needs in mind. Having a preset plan in place for your stock options prior to their vest date can help ease your decision making process, while relieving unnecessary stress and uncertainty.
Understand the potential tax implications
Another area that McGrady advises people to pay attention to is the potential tax implications that come with employee stock options. Options can have substantial tax implications compared to a typical stock sale, so it's critical to discuss potential tax consequences with your tax advisor.
He notes, "When you're exercising employee stock options, you are generating earned income. So it's taxed just like any other pay that you're receiving from your employer."
This is critical for planning purposes. Exercising your options can expose you to additional federal, state and local taxes, plus Social Security and Medicare payroll taxes. That can leave you with a greater tax burden than you might not expect or be prepared for.
In addition, depending on your current salary and the amount of income generated from exercising options, McGrady explains there's the potential of pushing yourself into a higher tax bracket. So, if it's already late in the calendar year, for example, discuss timing with your advisor to figure out if it's better to hold off for a few weeks until a new calendar year.
While the tax implications might not end up being a make-or-break scenario, it's good to know the consequences of your various choices, so you can plan accordingly and make a well-informed decision.
Determine your best strategy moving forward
In the end, what's most important is "making sure each employee understands the impact for their choices, and then makes a strategic decision in determining how [he or she] takes action" says McGrady.
The best way to do that? Discuss your employee stock options with your financial advisor and accountant. When it comes to exercising your options, there is no one-size-fits-all approach. Rather, you should incorporate your options into your broader personal financial strategy so that your exercising decisions are centered around your liquidity needs, risk tolerance, goals, and tax situation.