How do I use my stock options?
April 17, 2004 1:22 PM   Subscribe

Any investors out there? My company gave me some stock options for the last several years, and I haven't a clue how to to use them. [more inside]

I recently received a statement, which basically says for options granted 5/1/2002, i was granted 250 options, which 125 have vested. It says the income on the options if $12.295. What does all this mean, and how can I utilize this investment opportunity.
posted by benjh to Work & Money (12 answers total)
You should really visit a broker, they deal with this stuff all the time. They'll be able to help you purchase the options and understand the tax implications of having investment income.

For firms willing to accept small-time investors (less than $3-$5 thousand), you might want to check out TDWaterhouse or Edward Jones.
posted by falconred at 2:49 PM on April 17, 2004

Has your company gone public? Typically these options can't be converted into shares and sold until the company has gone public. If the company is public, talk to a broker soon about what to do with them. These shares can be worth a lot of money, but they also have serious tax issues you should understand before buying them. A friend of mine got hit with a $30,000 (!) tax on options he exercised, which was worth more than the actual value of the shares on the market. So don't touch them until you talk to an expert.
posted by Voivod at 4:25 PM on April 17, 2004

You seriously don't need a broker to find out the basics of what options are about... and in fact, I would recommend understanding the basics before you go talk to a broker, who is only going to be interested in extracting as many commissions from you for as long as possible. It just isn't rocket science.

Did you try google first? Searching for "employee stock option FAQ" yields lots of useful places to start reading, although I recommend ignoring anyone who looks they're trying to sell you something (at least to start). Or go to the library and find a book or two about personal finance.
posted by xil at 5:34 PM on April 17, 2004

I'll assume this is just a regular employee option type.

In general, an option is the right to buy a certificate of stock at a set price. When you were granted the block of 250 options in May of 2002, that price was set.

I don't know what the statement means when it says that the income on the options is $12.295 because you won't have "income" on the options until you've actually gone ahead and purchased the stock at that set price. (Is the 12.295 your exercise price?)

Usually, you can exercise (purchase) your options whenever you want--right away, even--but you can't sell the resulting stock until it's vested. That happens on a schedule. The simplest schedule would be a certain % of the option grant every X months.

Assuming you're in the US, there are profound tax implications for all this.

Why would you exercise on an option before you were able to sell it, considering that the exercise price is the same? Isn't that a silly thing to do with your money? Well, in the US, you incur a tax liability when you exercise a stock option, assuming that the current market value of the stock is higher than the option amount. The difference, if this is a regular employee option grant, is viewed by the IRS as regular income, just as if your employer had paid it to you in a paycheck. Well, the thing is that if you exercise on your options right when you get them, then they'll probably be worth the same or close to your "strike" (exercise) price. So, it wouldn't amount to a lot of taxable income, if any. On the other hand, if you don't exercise those options and the stock greatly increases in value, then upon exercise (not sale!) you'll be liable for the tax on the difference as regular income.

Any stock you've "vested" is stock you'd be allowed to sell if you exercise the option on it. Depending upon how long you've held the stock since you've purchased it, any gains you make from it when you sell it will be taxed as a capital gain.

So, to summarize. An option has a "strike price", which is how much you'd have to pay to exercise the option--that is, to buy a share of stock. There is, at any given moment, a fair market value for that share of stock, and it may well be different than your exercise price. Vested stock is stock that you'd be able to sell now if you exercised on the option (or if you already have). When you exercise, the difference between your exercise price and the fair market value is taxable income. When you sell, the difference between the fair market value at the time you exercised and your sale price is a capital gain or loss. How long you hold an exercised option before selling determines what kind of capgain it'll be (i.e., how it's taxed).

Unless those options are transferable, they don't have a salable value until you exercise on them.

Options that are "underwater" are options that are priced higher than the current fair market value of the stock. Something not uncommon for option grants granted in 1999 through 2001.
posted by Ethereal Bligh at 8:17 AM on April 18, 2004

"Well, the thing is that if you exercise on your options right when you get them, then they'll probably be worth the same or close to your "strike" (exercise) price. So, it wouldn't amount to a lot of taxable income, if any. On the other hand, if you don't exercise those options and the stock greatly increases in value, then upon exercise (not sale!) you'll be liable for the tax on the difference as regular income."

But if you exercise early and the stock goes up, then you're still liable for taxes, in the form of capital gains taxes (as you indicate). Given that, I don't see any good ethical (non-insider trading) case for exercising until the moment you are ready to sell.
posted by NortonDC at 9:30 PM on April 18, 2004

Aside from the fact that the capital gains tax is a lot lower than the income tax, you mean...
posted by kindall at 10:43 PM on April 18, 2004

That's not a given, is it? The dollar amount comes into play.
posted by NortonDC at 10:55 PM on April 18, 2004

You'd have to be in a relatively low marginal tax bracket for capgains to be higher than income tax. What is it these days? The Repubs want to eliminate it entirely.

But in my case, my exercised options were income all in the highest marginal tax bracket, whatever that was. (My tax bill one year was six figures.) I wish I had known to exercise when I'd got the options. Besides which, if you exercise and hold them for, um, three years or something, they turn into long-term capgains, which is lower.
posted by Ethereal Bligh at 3:30 AM on April 19, 2004

One very important, from a tax standpoint, distinction is whether your options are "non-qualified". If they are, there are fairly convoluted tax implications that can end up burning you if you're not careful.

If your company is publicly traded, they should be providing you with access to a broker to handle the transactions- in fact, they may be requiring you to go through a specific broker for the initial conversion to stock.
posted by mkultra at 7:14 AM on April 19, 2004

The big savings doesn't come from the income tax rate vs. the capital gains tax rate, it comes from the fact that you don't have to pay self-employment tax on capital gains. If it was treated as income, you would -- and that's over 15%, being both the employee's and the the employer's portion of Social Security (FICA). Even if your employer paid the employer's portion (and they wouldn't on options) that's still 7.65% you'd save above and beyond the difference in tax rate.

So, yes, definitely purchase as close to the strike price as possible, to minimize the income tax you have to pay and to treat the majority of any increase in value as a capital gain. If you hold onto the options longer than a year, the money you earn becomes a long-term capital gain and the tax rate falls even further.
posted by kindall at 10:00 AM on April 19, 2004

SS only taxes to 45K or thereabouts. Most people who get options are probably making at least that much in salary.

So, again, the big savings for most everyone in this situation would be converting it to capgains from income, and also converting it from short-term to long-term capgains.
posted by Ethereal Bligh at 10:34 AM on April 19, 2004

SS taxes apply to the first $87,000 made in a year.
posted by NortonDC at 6:39 PM on April 19, 2004

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