December 7, 2023


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Stock Option Gurus Explain 5 Financial Planning Topics To Contemplate

Taoism tell us that mindful strategic inaction, expressed in the concept of wu wei (literally “doing nothing” in Chinese), is usually the most effective approach to the challenges of living. It’s often the same with employee stock options. Waiting as long as possible to exercise stock options—i.e. doing nothing and letting the value grow until a strategic moment—is typically the soundest exercise strategy.

This planning consideration was a recurring theme in a recent webinar held by the website, Stock Option Exercise Strategies: Advanced Bootcamp. During the webinar, three experts in financial planning for stock options presented their tips for making the most of an option grant, including mistakes to avoid and advanced concepts for maximizing value. Some of the insights from these option gurus are summarized in this article.

It’s important to note that the two types of stock options have different tax treatments. Nonqualified stock options (NQSOs) are the more common type. Incentive stock options (ISOs) are less common and more complex in that they can offer potential tax advantages but more risk, including the alternative minimum tax (AMT). Most of the discussion in this article concerns NQSOs in public companies.

1. Waiting To Exercise Is Often Best

Stock options let you buy shares of your company’s stock at a fixed price for a specified period, typically over a term of 10 years. Under nearly all grants, you have to work at the company for a specified length of time (the vesting period) before you can exercise the options.

Alert: If you leave your company, the vesting stops and the term usually ends much earlier, requiring you to exercise the options soon after your departure to prevent forfeiture. These rules and time periods can vary according to the reason you left work (e.g. job change, disability, death, retirement).

Private companies sometimes grant stock options that employees can immediately exercise, allowing them to start the capital gains holding period sooner and recognize little or no income at this early exercise. You want to check whether you have this type of stock option and carefully follow the rules (e.g. a timely Section 83(b) election), though this is not the focus of the article.

Options Align Your Pay With Your Company’s Stock Price

In short, stock options let you share in the growth of your company’s value without any financial risk until you exercise the options (i.e. acquire shares). If your company’s stock price rises during the option term, the discount between the current stock price and your lower exercise price (the “spread”) can make stock options valuable for creating substantial wealth.

Leverage And Tax Deferral

The fixed purchase price creates the famous financial “leverage” of stock options. For example, if the stock price rises by 20%, the value of your unexercised stock options grows by much more than 20%.

As soon as you exercise the options and thus purchase actual shares of stock, the leverage ends. Thus it’s important to think carefully about the right moment to make that move.

Moreover, while cash bonuses and most other forms of compensation are taxable when you receive them, stock options defer taxes until exercise. Before you exercise your options, their built-in value is subject to pre-tax growth that can be significant.

For all of these reasons, the panelists in the myStockOptions webinar agreed: often no advantage exists in exercising nonqualified stock options in a public company soon after vesting, paying taxes on the spread, and then holding the shares for long-term capital gains (unless special circumstances occur, such as job termination). As long as the stock price continues to rise, thus increasing the spread over the exercise price, the leveraged value of the options grows without any tax hit, and your net after-tax proceeds will be larger.

In other words, the “Tao of Stock Options” might be the paradox that doing nothing for as long as possible could confer the greatest value.

Opportunity Cost And Exercise Timing

Consider also the opportunity cost of exercising and holding NQSOs. Financial advisors often liken stock options to an interest-free loan. “An option’s value is enhanced by the ability to use the capital that would otherwise be invested in the stock for some other investment,” said webinar panelist Bill Dillhoefer, CEO of Net Worth Strategies (creator of the StockOpter decision-making tool for employee stock options).

For example, he explained that if your options have a 10-year term and the company’s stock price keeps rising, the options have growing tax-deferred value before you have spent any money on them. Funds that you would otherwise put into buying the company’s stock can be used for other investments, then directed later into the option exercise at a strategic moment for larger gains.

Bill’s approach, which he detailed in the webinar, applies various ratios that consider special factors to calculate the optimum time to exercise options. For instance, when the stock price is much higher than the exercise price, these options with a big spread have less leverage and smaller upside from stock-price increases. These are the NQSOs that you might want to exercise and then immediately sell the shares.

2. Risk Versus Reward

Stock options involve risks as well as rewards. If the stock price plummets below your exercise price, the value of the options vanishes (i.e. they go “underwater”). Decisions about when to exercise must therefore factor in the outlook for the company’s stock price.

The webinar panelists also discussed the risk of overconcentration, i.e. having too much of your net worth tied up in the stock of just one company. A single stock price can quickly fall. A diversified stock portfolio helps to mitigate that risk. When you calculate your concentration level, you should include any vested stock options you have. That can give you yet another reason to wait on exercising your options until you have a solid post-exercise plan that includes selling shares for diversification.

How can you balance the risks and the rewards? “Fundamentally, it is useful to base decisions with any type of equity award primarily on financial goals, timeframes for those goals, and the investment risk along the way,” explained David Marsh, Financial Planning Case Manager with Ameriprise Financial.

“Create perspective,” asserted his fellow webinar panelist Megan Gorman, a financial advisor, founder of Chequers Financial Management, and a Forbes senior contributor. “If you show the best-case scenario, also show the worst.”

To lessen concentration risk and promote diversification, a strategy formulated with a financial advisor should also extend well beyond exercise, explained Megan. “Have a strategy on selling stock and where the proceeds are going to be reallocated to.” When you have a strategy, one way to document it (and provide some protection from insider trading accusations) is with a Rule 10b5-1 trading plan. She uses these for her executive clients.

3. Taxes

All of the webinar panelists agree that taxes should not be the principal driver of decisions. “While taxes are key factors, it’s dangerous to base decisions principally on tax aspects and neglect coordination with goals and investment risk,” warned David Marsh. In other words, chimed in Megan Gorman, the tax tail should not wag the option dog.

Nevertheless, Megan continued, it is important to model tax scenarios for your stock options and be prepared. “To build wealth, you have to deal with tax consequences.”

She added that for NQSOs you should “be prepared for your company’s tax withholding at exercise to not be sufficient to cover the tax bill.” The IRS default statutory withholding rate of 22% for supplemental income, such as the spread at option exercise or restricted stock unit (RSU) vesting, is often lower than your actual income-tax rate.

While the withholding rate jumps to 37% for supplemental wage income in excess of $1 million during the calendar year, when you fall between those extremes, plan how to pay the taxes not covered by the 22% default rate. The shortfall in federal and/or state taxes can be paid in quarterly estimated tax payments based on the additional amount owed, among other methods.

4. Understand The Stock Plan Documents

One of the biggest mistakes with stock options is failing to read the stock plan documents and not fully understanding the terms of the grant, according to the experts in the webinar. “Grant info needs to be organized, saved, and updated to provide ongoing guidance,” cautioned Bill Dillhoefer.

Chief among the option terms to know are the vesting provisions and what would happen upon job termination, which usually triggers a very short window for option exercise before the grant term expires. “It’s crucial to clarify equity awards’ terms for vesting and at separation of service,” stated David Marsh. “Realize they may not all be the same for all grants.”

He also noted that many optionholders neglect to designate a beneficiary for vested stock options in case of death. “This is usually allowed in the plan, but often employees are unaware of that.”

5. Seek Help From A Qualified Advisor

“Stock options are complex employee benefits,” asserted Megan Gorman during her segment of the webinar. “Complex benefits require us to move slowly and think through issues.”

She implores employees to obtain guidance from a financial advisor and tax experts with experience in stock options and restricted stock, and to avoid relying on tips from co-workers. “Exercise strategies are incredibly personal,” Megan emphasized. “For your own unique situation, you may need to do very different things than your colleagues.” Bill Dillhoefer echoed this sentiment, observing that applying advice from “water-cooler” chats with co-workers about stock options can lead to mistakes.

More Insights Into Option Exercise Strategies

For many more insights about option exercise strategies, see the financial-planning articles by various experts at In addition, the webinar where Bill, David, and Megan presented planning ideas and case studies, involving both NQSOs and ISOs in public and private/pre-IPO companies (Stock Option Exercise Strategies: Advanced Bootcamp), is available on demand at the myStockOptions Webinar Channel. A separate webinar on restricted stock and RSU financial planning is also available on that channel.