The Ins And Outs Of Stock Options

For many high-level employees, stock options may have become too much of a good thing. Many employees have amassed enormous wealth from stock options, but their long-term financial success may depend too heavily on the continued success of their employer.

In today's changing economy with employment creeping slightly higher and a new administration in the White House, it is prudent to explore a variety of investment strategies. If a high percentage of the executive's net worth is concentrated in their company's stock, now is the time to diversify. Several considerations must be evaluated when planning the exercise or sale of the employee's securities, including: the risk the employee is willing to assume, the risk to the business and tax considerations. A plan should be carefully developed to exercise the options for diversification and to avoid tax consequences.

When options are granted there is no tax event be-cause the options are qualified or non-qualified. The tax treatment varies when the options are exercised de-pending on whether the options are qualified or non-qualified.

Non-Qualified Options (NQ)

The tax treatment of NQs is simple but it also the most expensive from a tax perspective. When NQs are exercised, ordinary income in the amount of the "spread" is recognized. The spread is the fair market value of the shares on the date of exercising less the cost of the option. This income will be included in the individual's W-2 and the employer will be required withhold 28% and 5.95% for federal and state taxes respectively. The spread will also be subject to -

Social security, Medicare and local taxes. When NQs are exercised, sell the security immediately because the cash will be needed for the cost of the options and the taxes. All options will expire in ten years and some cases earlier. Hold onto NQs for as long as possible to allow the options to grow tax deferred. However, balance this decision of holding the options based on the overall investment approach and the cur-rent diversification of the portfolio.

There is little to no tax planning with NQs. Exercise these options when the stock price is high. However, they will help with the tax implications of Incentive Stock Options.

Incentive Stock Options (ISO)

The planning comes into play when dealing with ISOs. If the executive properly plans, taxes can be cut in half with ISOs. Options that are exercised and held for one year will not be subject to regular income taxes in the...