Employee Stock Options: WWHBD?

[cowboyhat]

Looking through the archive I couldn't find a discussion on what to do with employee stock options.
Did Harry Browne express an opinion on how to fit them into a PP?

As an orthodox PP investor I want to invest according to HB's definition, and not speculate.

Sticking to HB's definition of investing makes deciding what to do with employee stock grants easy: sell them as soon as possible and invest the proceeds in PP.

The best logic for options is harder for me to see. Options seem to force speculation. When granted they are worth nothing or a few pennies, but they have the potential to become enormously valuable... for a speculator.

Any thoughts on a rule for exercising options that embodies the investing philosophy?

[craigr]

IMO. When options vest you exercise and diversify. Holding onto them is a speculation in the company. The problem is you have two risks:

1) The stock could nose dive and even fall below your exercise price so you paid taxes on shares worth less now if you exercised but didn't sell.
2) Usually when a stock dives the company is having problems that could result in layoffs that may include your own job. So right when you need your savings to buoy you between work they are falling steeply in price.

There are other risks as well but those are the biggies. So unless you are in some kind of restricted plan or start-up that hasn't gone IPO so you could even sell your shares, I'd recommend exercise and sell personally.

But this issue can get very complicated depending on each person's own tax situation as well. So it may make sense to talk about the options to a qualified tax professional familiar with your situation.

[Storm]

I've asked for advice a couple times here in this forum about my employee options.  Basically, I can purchase $25K worth of company stock a year at 15% below market price.  In addition, I get PeRSU (performance restricted stock units) that vest 25% per year for 4 years and have a strike price at the time they were issued, each year.

The general consensus/advice was exactly as CraigR said above.  They are part of a VP, and should be sold as soon as you can based on tax law and diversified.  So, my approach is to exercise them and then sell at least 1 year later so that the profit realized is long term capital gains.  I then roll that money into the PP.

This has proven extremely effective for me.  Basically, I've been averaging at 35% profit on my $25K a year, and using all of the proceeds to feed the PP.  If all goes well I can retire 10 years from now at the age of 48...

Fingers crossed... 

[Pointedstick]

I've asked for advice a couple times here in this forum about my employee options.  Basically, I can purchase $25K worth of company stock a year at 15% below market price.  In addition, I get PeRSU (performance restricted stock units) that vest 25% per year for 4 years and have a strike price at the time they were issued, each year.

The general consensus/advice was exactly as CraigR said above.  They are part of a VP, and should be sold as soon as you can based on tax law and diversified.  So, my approach is to exercise them and then sell at least 1 year later so that the profit realized is long term capital gains.  I then roll that money into the PP.

This has proven extremely effective for me.  Basically, I've been averaging at 35% profit on my $25K a year, and using all of the proceeds to feed the PP.  If all goes well I can retire 10 years from now at the age of 48...

Fingers crossed... 

Heh, that's very similar to what I've been doing too. I've experienced returns like yours as well, and I have to say, it's really satisfying. I just paid off the last of my wife and my student loans with some company stock two days ago, and now we're officially debt-free!

[jackely]

Stock options used to be fairly common for top IT professionals but I rarely hear of it any more.

Back when I got them I always exercised them as soon as they became vested, sold the stock immediately, and re-invested the proceeds. And that's what everybody else I knew did also.

If you do this, be careful when you do your taxes. The last time I exercised stock options the proceeds were taxed as ordinary income so I thought I didn't need to do any accounting for it when I filed. Little did I know that the company filed a 1099 to report the proceeds. I ended up getting a letter from the IRS saying I owed about $38k. Fixing it was a simple matter of filing a schedule D to account for the 1099 but it was a bit unnerving before I figured it all out.

[Storm]

Stock options used to be fairly common for top IT professionals but I rarely hear of it any more.

Back when I got them I always exercised them as soon as they became vested, sold the stock immediately, and re-invested the proceeds. And that's what everybody else I knew did also.

If you do this, be careful when you do your taxes. The last time I exercised stock options the proceeds were taxed as ordinary income so I thought I didn't need to do any accounting for it when I filed. Little did I know that the company filed a 1099 to report the proceeds. I ended up getting a letter from the IRS saying I owed about $38k. Fixing it was a simple matter of filing a schedule D to account for the 1099 but it was a bit unnerving before I figured it all out.

This is why I feel that it's best to exercise, then hold the stocks in a brokerage account for at least 1 year and a day before selling.  The difference between 15% long term capital gains and regular income tax rate is astounding.  Of course, a lot of times when people get a big payout like that it is tempting to take the cash and buy a house or some nice car or something...  Try to resist the temptation.  Easier said than done,  but if you can at least resist temptation for a year you're effectively paying about 10-20% less for whatever big ticket item you want to buy.

Personally I've never been lucky and gotten a big options payout.  My company is a Fortune 15 company so the gains are slow and steady, but that's fine with me.  It also means less volatility and risk.

[cowboyhat]

My employer is a gigantic corporation and the stock price generally moves slowly.

The way the options work is that they vest in 1/3s over three years. So, for example, if I were awarded 3000 options I would have the right to exercise 1000 after 1 year against the price the day the award was given, 1000 the next year, and 1000 the third year. The options expire worthless if not exercised after 10 years.

My experience is that they are often underwater or worth a very small amount when they vest. So for example if my employer's stock price moved up $0.10 during the vesting year my first 1000 options would be worth $100.  Seems like a shame to exercise them for $100. It's not that I wouldn't be happy to have an extra $100, but losing $100 is not going to break me financially and the 1000 options have potential to be worth much more (or of course nothing at all) and I have a 10 year event horizon on them.

What I have been using is the 1/2 a paycheck rule. Since I would genuinely regret the loss of an amount of money equal to 1/2 of a paycheck, when combined value of all vested options equals 1/2 a paycheck I exercise them. This is a dumb rule of thumb and it's not very satisfying to me in terms of knowing I got the most out of the options, or at least made the most rational decision regarding the exercise. Seems like the time left to expiration should be more of a consideration. 10 years is an awfully long time though.

[jackely]

This is why I feel that it's best to exercise, then hold the stocks in a brokerage account for at least 1 year and a day before selling.  The difference between 15% long term capital gains and regular income tax rate is astounding.  Of course, a lot of times when people get a big payout like that it is tempting to take the cash and buy a house or some nice car or something...  Try to resist the temptation.  Easier said than done,  but if you can at least resist temptation for a year you're effectively paying about 10-20% less for whatever big ticket item you want to buy.

Personally I've never been lucky and gotten a big options payout.  My company is a Fortune 15 company so the gains are slow and steady, but that's fine with me.  It also means less volatility and risk.

Most of my payouts have been big because they all came suddenly as a result of my company being bought by another company, thus causing all options to become 100 percent vested immediately. Back in those days I never actually had enough money to purchase the stock myself but there were always brokerage firms standing by to float the money in return for our business on the re-investments (which I eventually learned they were ripping us off on - Smith Barney to name names).

Even if I had the cash to buy the stock myself and hold it I don't understand your strategy though. I thought that the minute the stock was issued in your name you had an ordinary income taxable event representing the difference between the option price and the market value. I didn't think there was any way around that. If there was I was mistaken. Believing this to be true I didn't see any advantage in holding company stock vs investing in something else.

[Storm]

Even if I had the cash to buy the stock myself and hold it I don't understand your strategy though. I thought that the minute the stock was issued in your name you had an ordinary income taxable event representing the difference between the option price and the market value. I didn't think there was any way around that. If there was I was mistaken. Believing this to be true I didn't see any advantage in holding company stock vs investing in something else.

I could be wrong, but I believe it's only taxable when you sell them and realize the profit.  A lot of people do this if they want to convert them to cash (option strike price is $10, stock is worth $100, if you don't have any money you can still exercise the option and sell immediately and pocket $90).

http://www.irs.gov/taxtopics/tc427.html

Personally, I think it would actually be better to take out a home equity loan or anything you can do to hold the stock, provided you don't think the company will completely tank in the next year.  Then, shoot for the long term capital gains if you can.  If you had to borrow money to exercise the option you could set a stop limit sell order to limit your downside risk.

[craigr]

Stock options come in many flavors. Non qualified options will be taxed as income when you exercise. Typically you work with a broker who will sell off the shares to both buy the stock and pay taxes. You keep the difference after the transaction is over. I know a ton of people that got badly burned by exercising options and not selling them immediately to diversify. I always recommend you diversify unless you happen to be in some very particular situation with start-up options with a good chance for significant appreciation and you want to gamble. But mostly if it's a well established company the best bet is to not to mix career with your savings and diversify.

Then again some companies have incentive stock options which could be treated as long term gains. It all depends on the situation. This is the main reason why I suggest people discuss their individual matters with a qualified tax professional to avoid getting a potentially very large tax bill. As I said, I've known some people personally get badly burned with appreciated options that didn't diversify but still owed huge taxes on the now non-existent gains. Caveat emptor!

[Lone Wolf]

As I said, I've known some people personally get badly burned with appreciated options that didn't diversify but still owed huge taxes on the now non-existent gains. Caveat emptor!

Yes, I've seen this as well and it's financially quite painful for those it happens to.  Unfortunately, there are real risks to the approach of exercising and then holding for a year, in spite of its tax efficiency perks.

The choice between simply quick-selling the options and rolling the dice for long-term capital gains will be a personal one that depends a lot on your situation, the volatility of the company issuing the stock, your tax bracket, and your risk tolerance.

[Storm]

Some very good points on diversification.  A lot of people got burned in the dot com crash because they thought their stock would never go down.  My risk profile working for a large company in a defensive sector that's been around for 175 years is a lot different than working for an Internet startup.  The point Craig made about everyone's situation being different is very astute.