When the market turns bearish, investors want to know how they can best protect their assets and secure their financial future. It’s always important to keep in mind certain fundamentals, such as the cyclical nature of the market and the importance of diversification, but what if you’ve received stock options from your employer?
In many cases, a down market can provide a good opportunity to exercise options at a lower tax cost. Additionally, if the turbulent economy puts your job in jeopardy, you may need to exercise sooner rather than later to avoid missing the opportunity entirely. Consider the following questions when deciding what to do with your stock options while the market is down.
What kind of stock options do you have?
Different types of stock options are taxed differently. Understanding how you will be taxed on your equity compensation is the first step in understanding any potential savings you could generate by exercising options while their fair market value is depressed.
Incentive stock options (ISOs) are a popular form of equity compensation that gets special tax treatment and is available only to a company’s employees. When an employee exercises stock options, the difference between the price they pay (often called the strike price) and the current fair market value of the shares is known as the bargain element. With ISOs, the bargain element isn’t taxed directly; rather, it’s included in the alternative minimum tax (AMT) calculation.
Nonqualified stock options (NSOs) are another type of equity compensation. NSOs can be granted not only to employees but also vendors, contractors, board members, and other associates of the company. The bargain element of an NSO exercise is taxed as wages.
Can you early exercise?
If you have unvested stock options, find out whether your company allows early exercise—the exercise of stock options before they vest. No matter what the market conditions, early exercise can often result in considerable tax savings for employee shareholders. In pre-IPO companies, the bargain element is typically small; when the market is in bear territory, it’s likely to be even smaller.
Early Exercise and 83(b)
To take advantage of the tax savings that early exercise can offer, you must file an 83(b) election within 30 days of the exercise date. By filing at 83(b), you’re opting to report the bargain element for tax purposes at the time of exercise rather than at the time your shares vest. Otherwise, the bargain element will be reportable (either for the AMT or as wage income, depending on whether you have ISOs or NSOs) at the time of vesting, when the fair market value may be considerably higher.
Are you in danger of losing your job?
If the economic downturn is putting your employment at risk, then you may not have your stock options for as long as you’d expected. Particularly if you have ISOs, it’s important to be prepared to act quickly in case you lose your job. As mentioned above, ISOs are available only to employees of the issuing company. If you’re let go, you have just 90 days after termination to exercise them. After that, if your plan agreement still allows you to exercise, they will automatically be converted to NSOs. It’s more common for plan agreements to allow longer exercise windows for NSOs, which can extend for up to ten years after the grant date.
Can you afford to exercise options?
Don’t forget to budget for taxes.
When you exercise stock options, you need to not only come up with the strike price but also be prepared to cover any tax liability that results. Because the tax rules around stock options are complex, it’s important to consult a tax planner who has experience working with pre-IPO employees. They can help you understand the tax consequences of exercise so you can avoid unpleasant surprises and be prepared when tax time rolls around.
Loans could provide funding for exercise.
Many employee shareholders access loans to help them secure their early stakes in their companies, allowing them to profit from the hard work they put in during the leaner years. Your investment advisor can talk to you about different types of loans you might consider, such as a margin loan, home equity loan, or consumer loan. There are some companies that specialize in non-recourse loans for stock options. Of course, with the Fed’s recent interest rate bumps, loans have quickly become more expensive.
Secondary markets could provide some liquidity.
While the secondary market is also less robust presently, some companies allow their employees to trade pre-IPO stock in this way. If yours is among them, you may be able to exercise and sell some of your options on the secondary market as a way of generating cash to exercise the rest. If you are struggling to afford the stock purchase price or are unsure about betting on your company, this could provide a financially safer way of investing. It avoids the obligation to repay a loan for shares that may—but also may not—later be worth much more than their purchase price.
At WRP, we specialize in guiding employee investors through the IPO process, helping them grow their wealth to create the future they desire. For more tips on managing your stock options, subscribe to our blog or browse our free resource center.