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4 Mistakes to Avoid with Your Company Stock Option Plan
Make sure you maximize your stock option benefits by avoiding these four mistakes.
Participating in your company stock option plan can be a great source of wealth. But stock option plans are often complex, and the consequences for making a mistake can be substantial. You could face a large, unexpected tax bill, take on unnecessary risk, or lose the right to exercise your options entirely.
Make sure you maximize your stock option benefits by avoiding these four mistakes:
1. Don’t Always Choose In-The-Money Options Over Stock
Stock options are more risky than common stock. And yet, when it comes time to diversify by selling company stock, some people choose to hold on to the riskier options over regular common stock. While options carry significant upside leverage, remember that they are a use-it-or-lose-it proposition. If your options expire below the exercise price during a downturn, they’re worthless. Company stock can recover over time. Options don’t.
Company stock options are also subjected to different tax rules. Stocks held for more than a year will be subjected to lower capital gains tax. But depending on the type of option, you could pay ordinary income tax, alternative minimum tax, or capital gains rates. Common shares also may pay a dividend, whereas options never will.
2. Don’t Skip on Making a Strategy
Many employees simply believe that their company stock will perpetually increase in value, so they wait until the last minute to exercise their options to make the most off the option. This wait-until-later approach can be a bad idea. If something happens at the last minute — from a paperwork delay, getting caught in a “quiet-period,” or just forgetting the deadline — you’ll lose the chance to exercise altogether.
Also consider the tax implications of your decision as well. Exercising your options is a taxable event. The IRS considers the difference between the current fair market value and your exercise price as income, either as ordinary income (for a Non-qualified Stock Option) or as an AMT item (for Incentive Stock Options).
Keep track of your options’ expiration dates and develop an exercise plan for them at least a year in advance, giving you time to project cash flow and tax implications. If you can create a plan to exercise when you are in a lower tax bracket, you might make more money in the end.
3. Don’t Ignore Your Options When You Leave
Your company can change the terms of your options. Typically, your plan will change upon quitting or being fired from the company. You’ll probably have no more than 90 days from your last day of work (not the last day of your severance package) to exercise your options. This shortened time limit gives less time for your options to appreciate in value. But if you are caught unaware, you might let your options expire altogether.
It’s also possible for the stock option plan to change during company mergers and acquisitions. Your vesting schedule might be accelerated, or you might be able to immediately exercise your option. Check with your HR department so you can make the best decision for your portfolio.
4. Don’t Forget to Consider an 83(b) Election
A section 83(b) election is a notice you give to the IRS that you would like to be taxed on your equity (such as restricted stock options) on the date the equity was granted to you rather than on the date the equity vests. Why would you pay tax on stock before vesting? The answer is taxes.
The ability to make a section 83(b) election allows you to change the tax treatment on your option gains from ordinary income to a long-term capital gain, which is taxed at a much lower rate. The tax code rewards those who hold their investments for more than one year with discounted taxes. Currently, the highest long-term capital gains tax is 20%, versus the highest ordinary income tax rate of 37%. The goal of a section 83(b) election is to get as much of your gain taxed at the lower capital gains rate.
By making a section 83(b) election, you are paying tax on the value of the shares at the time they are granted to you. All future gains between the grant date and final sale will be considered capital gain. Normally, you only pay tax on options when they become vested to you (not granted to you); and any gain between the grant date and vesting date is taxed at ordinary income rates. So a section 83(b) election starts the clock on long-term capital gains rate right away.
Section 83(b) does have risks: if you are given large amounts of restricted stock, it creates a large tax bill and you can’t sell any shares to help cover the taxes. And if the company fails or falls in value before your stock vests, you’ll have paid taxes for nothing in return. But if you’ve been given a small amount of stock and you have reasonable confidence in your company’s long-term prospects, it is worth it to consider paying some tax up front and lock in the lower rates for future gains.
You must file an 83(b) election within 30 days of when you are granted the restricted company stock. The grant date is usually the date the board approves the grant, even if you don’t receive the paperwork right away. Taking advantage of your company stock option plan can help you build wealth. But make sure to consult a tax professional and a financial planner to make the most of your options. You don’t want to be surprised by a huge tax bill.