One of the best things to come out of tech company culture (aside from office arcade machines and beer on tap) is the philosophy that employees ought to share in the upside of the value that they help create. If you work for a company that shares these beliefs, chances are you have received stock options; the “option” to purchase your employer’s stock at a certain price within a certain time horizon.
Companies do a great job of generously distributing stock options, but due to their complicated nature, most companies really lack in the area of educating their employees on the value and tax implications of their equity. Not surprisingly, the one question we hear most from our clients is, “when is the best time to exercise my stock options?”
This question brings up two fundamental concepts relating to wealth management: Taxes and diversification.
Assuming you have received Incentive Stock Options (ISOs), you likely have a degree of control over the tax outcome. The two taxable events to consider are:
- When you exercise your stock options.
- To “exercise” your stock options means to purchase your employer’s stock at a given price (the “strike price”). When you do this, your company will calculate the Fair Market Value (FMV) of the shares on the date of exercise. The difference between the FMV and your strike price is referred to as the “bargain element” and it is going to be reported as compensation on the AMT (Alternative Minimum Tax).
- When you sell your shares.
- Once you exercise your stock options, you receive common shares of your employer’s stock. You can then hold those shares or sell them, but there are tax implications for each scenario.
Let’s take a look at these two considerations with the following example: You have been granted 10,000 options at a strike price of $5. Current FMV is $15 per share.
Assuming you exercise all your options at the current FMV of $15 per share, you will likely incur an AMT tax obligation of around $28,000. This is calculated as: (10,000 shares * ($15 sale price – $5 strike price)) * 28%. This essentially means that you bought 10,000 shares for $5 at a time when they were actually worth $15, and the spread must be considered compensation for tax purposes.
After exercising, you are now a shareholder with 10,000 shares to your name. The tax you ultimately pay on the investment side of this transaction will depend upon how long you hold your shares.
If you sell your shares anytime within 12 months of exercising, your AMT obligation will disappear (AMT only comes into play if you hold the shares for longer than one year). However, you may end up paying a higher tax, because the spread between the strike price and the sale price will be taxed at your normal income rate if you sell within 12 months.
If you sell your shares MORE than 12 months after exercising your options (and at least 2 years after your options were initially granted to you, which is typically at the star of your employment), you would qualify for the more favorable long-term capital gains tax.
Here’s the takeaway: In general, if you can exercise your options and wait 12 months before selling the shares, you will be subject to a substantially lower tax expense.
The second element to consider in answering the question of when to exercise your stock options is wealth diversification. Especially for younger employees who got in early at a high-growth company, it is possible to have substantially all of your net worth tied up in your stock options. While the rate of growth in these options may have been astronomical over the past few years, very rarely does this trend continue into the future.
In fact, if you look at companies like Twitter, Linkedin, Tableau (really any tech company that has gone public), the high share prices eventually hit a ceiling before the market readjusts the share prices to a more reasonable valuation. Looking at LinkedIn as an example, the stock IPO was $93, it peaked at $252, and fell back down to $100 three months later. If a significant portion of your net worth is handcuffed to this volatility, you will likely find it very difficult to sleep at night, let alone effectively plan around your wealth.
Therefore, it is often a good idea to exercise stock options as a means of tapping the wealth and placing it into a more stable and diversified investment portfolio. If you elect to keep a portion of your shares unexercised as a speculative investment, that is totally understandable. But in almost any scenario, it makes sense to lock-in the majority of those gains as soon as possible.
Each person is different
If after reading this post you are still asking yourself, “so… when is the best time to exercise my stock options?” then you are not alone. It is impossible to give a specific answer to that question without taking a look at the entire picture.
The Vestboard equity dashboard is a great (free) tool to use for visualizing and planning around your stock options. Simply create a profile and our platform will automatically translate your stock option agreement into some very clean and simple charts that track the value of your equity over time. We will generate tax estimates and when you are ready to exercise your options we have a team of CPAs who are standing by to assist. This is a serious decision and you will want an expert to take the time to learn your situation and offer the best advice.
Disclaimer: This article is intended as general information only and should not be interpreted as investment or tax advice. Vestboard makes no guarantees as to the accuracy, completeness, suitability, or validity of any information contained on this site. Each individual has their own unique circumstances which must be taken into consideration. Financial advice is only granted to individuals who become Vestboard clients. Past performance does not guarantee future results.