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Money Cents

Strategies for Exercising Employee Stock Options
By Shelley Phillips-Mills
Feb 21, 2005 - 3:40:00 PM

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A stock option is the right to purchase a companyís stock in the future at a fixed price. Many companies now grant stock options to build loyalty, tie performance to compensation, and to reward dedicated employees. However, thousands of stock options expire each year. Many people are unsure about when and how to exercise their options and the financial challenges they may create. While specific tax questions should be directed to your tax advisor, letís take a look at the basics of stock options.

There are two types of options: nonqualified stock options (NSOs), the most common type, and incentive stock options (ISOs). They differ mainly in the tax consequences to you and the granting company.  When options are granted, you donít incur taxes because there is no transfer of property at grant date.

Nonqualified stock options may be granted at a value less than the current market price. When NSOs are exercised, you pay ordinary income tax on the difference between the option price and the current market price (your NSO cost basis) at time of exercise.

Incentive stock options are granted at a price at least equal to the stockís market price at that time, meaning the stockís price must increase for you to benefit. When ISOs are exercised and then the stock sold, the difference between the sale price and the option price (your ISO cost basis), is the income for tax consideration. If you hold the stock received from your ISO exercise for the required period, this difference (spread) is a long-term capital gain or loss and will likely receive favorable tax treatment. If you do not hold the stock for the required period then your ISOs are treated as though they were NSOs.

As you contemplate exercising your options, there are a few things to consider:

How much time remains until the stock options expire. Keep in mind that once the options expire, they have no value.

Whether you intend to exercise and hold. Itís important to look at your timing when you decide to exercise options.  If you are planning to exercise your options and hold them, youíll want to do so when the stock price is close to the option price Ė meaning a smaller spread Ė in order to lessen the tax impact. If you are planning to exercise and sell your options and your goal is to generate cash, youíll want to do this when the stock price is further from the option price and the spread is larger.

The rules of your plan. Generally, you don't have to exercise all of your options at once. However, minimums and holding periods may apply so check your plan rules.

Leaving employment. Are you planning on retiring? If so, you need to determine how departure from the company will affect your optionsí vesting and/or expiration schedule.

Your asset allocation. You should consider stock options as part of your equity allocation. How well balanced is your overall portfolio? If you are granted a large number of stock options, you should discuss diversification strategies with your financial consultant.

As you develop a strategy for exercising your options, make sure you include your financial consultant along with your team of tax and legal advisors. If you would like to receive the publication, Understanding Employer-Granted Stock Options, by A.G. Edwards & Sons, Inc, please contact financial consultant, Shelley Phillips-Mills at 800-947-5456.


This article was provided by A.G. Edwards & Sons, Inc., Member SIPC


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