- Don't get over-concentrated in your employer's stock. Find ways to diversify.
- Don't delay exercising your stock options to the last minute, waiting for the stock price to go up. If you miss the deadline, your stock options will expire worthless.
- If you leave your company due a new job, a layoff, or retirement, you will typically have no more than 90 days to exercise any existing stock option grants.
Stock options and employee stock purchase programs can be good opportunities to help build potential financial wealth. When managed properly, these benefits can help pay for future college expenses, retirement, or even a vacation home.
But many investors get tripped up, don't pay attention to critical dates, and haphazardly manage their employee stock option grants. As a result, they may lose out on the many benefits these stock option plans can provide.
To help ensure that you maximize your stock option benefits, avoid making these 6 common mistakes:
Mistake #1: Allowing in-the-money stock options to expire
A stock option grant provides an opportunity to buy a predetermined number of shares of your employer's company stock at a pre-established price, known as the exercise or strike price. Typically, there is a vesting period ranging from 1 to 4 years, and you may have up to 10 years in which to exercise your options to buy the stock.
A stock option is considered "in the money" when the underyling stock is trading above the original strike price. Say, hypothetically, you have the option to buy 1,000 shares of your employer's stock at $25 a share. If the stock is currently trading at $50 a share, your options would be $25 a share in the money. If you exercised them and immediately sold the shares at $50, you'd enjoy a pretax profit of $25,000.
You may be tempted to delay exercising your stock options as long as possible in the hope that the company's stock price continues to go up. Delaying will allow you to postpone any tax impact of the exchange, and could increase the gains you realize if you exercise and then sell the shares. But stock option grants are a use-it-or-lose it proposition, which means you must exercise your options before the end of the expiration period. If you don't act in time, you forfeit your opportunity to exercise the option and buy the stock at the strike price. When this happens, you could end up leaving money on the table, with no recourse.
In some cases, in-the-money options expire worthless because employees simply forget about the deadline. In other cases, employees may plan to exercise on the last possible day, but may get distracted and therefore fail to take necessary action.
"Ask yourself how much extra value you may get by waiting until the last second to exercise your award, and determine if that's worth the risk of letting the award expire worthless," says Scott Senseney, senior vice president, Fidelity Stock Plan Services.
Consider these factors when choosing the right time to exercise your stock options:
- What are your expectations for the stock price and the stock market in general?
- If you think the stock has peaked or is likely to fall in the future, consider exercising and selling. If you think it may continue to go up, you may want to exercise and hold the stock, or delay exercising your options.
- How much time remains until the stock option expires?
- If you are within 60 days of expiration, it may be time to act, to avoid the risk of letting the options expire worthless. Check with your employer about any black-out periods or other restrictions.
- Will you be in the same tax bracket, or a higher or lower one, when you are ready to exercise your options?
- Taxes have the potential to eat into your returns, so you may want to exercise and sell when you are in the lowest tax bracket possible—though this is just one factor to weigh in your decision.
Tip: Monitor your vesting schedule, keep your contact information updated, and respond to any reminders you receive from your employer or stock plan administrator.
Mistake #2: Failing to understand the tax consequences of ISOs
There are 2 kinds of stock option grants: incentive stock options (ISOs) and nonqualified stock options (NSOs). When you receive an ISO grant, there's no immediate tax effect and you do not have to pay regular income taxes when you exercise your options, although the value of the discount your employer provided and the gain may be subject to alternative minimum tax (AMT).
However, when you sell shares of the stock, you'll be required to pay capital gains taxes, assuming you sold the shares at a price higher than your strike price. To qualify for the long-term capital gains rate, you must hold your shares at least 1 year from the date of the exercise and 2 years from the grant date.
If you sell ISO shares before the required holding period, this is known as a disqualifying disposition. In such a case, the difference between the fair market value of the stock at exercise (the strike price) and the grant price—or the entire amount of gain on the sale, if less—will be taxed as ordinary income, and any remaining gain is taxed as a capital gain. For most people, their ordinary income tax rate is higher than the long-term capital gains tax rate.
While taxes are important, they should not be your sole consideration. You also need to consider the risk that your company's stock price could decline from its current level. "Be aware of your tax situation, but also understand how the company is performing in the marketplace, because there are also risks to continuing to hold the shares," says Senseney. "Know which shares are qualified for special tax treatment, what the holding periods are, and exercise stock options accordingly."
Tip: Consult with a tax advisor before you exercise options or sell company stock acquired through an equity compensation plan.
Mistake #3: Not knowing stock plan rules when you leave the company
When you leave your employer, whether it’s due to a new job, a layoff, or retirement, it's important not to leave your stock option grants behind. Under most companies' stock plan rules, you will have no more than 90 days to exercise any existing stock option grants. While you may receive a severance package that lasts 6 months or more, do not confuse the terms of that package with the expiration date on your stock option grants.
If your company is acquired by a competitor or merges with another company, your vesting could be accelerated. In some cases, you might have the opportunity to immediately exercise your options. However, be sure to check the terms of the merger or acquisition before acting. Find out if the options you own in your current company's stock will be converted to options to acquire shares in the new company.
Tip: Contact HR for details on your stock option grants before you leave your employer, or if your company merges with another company.
Mistake #4: Concentrating too much of your wealth in company stock
Earning compensation in the form of company stock or options to buy company stock can be highly lucrative, especially when you work for a company whose stock price has been rising for a long time. At the same time, you should consider whether you have too much of your personal wealth tied to a single stock.
Why? There are 2 main reasons. From an investment perspective, having your investments highly concentrated in a single stock, rather than in a diversified portfolio, exposes you to excess volatility, based on that one company. Moreover, when that company is also your employer, your financial well-being is already highly concentrated in the fortunes of that company in the form of your job, your paycheck, and your benefits, and possibly even your retirement savings.
Second, history, is littered with formerly high-flying companies that later became insolvent. When Enron filed for bankruptcy in 1999, more than $1 billion in employee retirement savings evaporated into thin air. Lehman Brothers employees shared a similar fate in 2008 as did Radio Shack workers in 2015. Consider, too, that income from your employer pays your nondiscretionary monthly bills and your health insurance. Should your company's fortunes take a turn for the worse, you could find yourself out of a job, with no health insurance and a depleted nest egg.
"Stock from an equity plan is usually a large component of an employee's annual compensation, so it's easy for your portfolio to become overly concentrated in your employer's stock," says Senseney. "But you need to take a step back, consider how these benefits fit into your long-term financial objectives, such as college savings, retirement, or a vacation home, and develop a plan to diversify accordingly."
Tip: Consult with a financial advisor to ensure that your investments are appropriately diversified and read Viewpoints on Fidelity.com: The risk of a concentrated portfolio
Mistake #5: Ignoring your company's employee stock purchase plan
Employee stock purchase plans (ESPPs) allow you to purchase your employer's stock, usually at a discount from the stock's current fair market value. These discounts typically range from 5% to 15%. Many plans also offer a "look-back option," which allows you to buy the stock based on the price on the first or last day of the offering period, whichever is lower. If your company offers a 15% discount and the stock rose 5% during the period, you could buy the stock at a 20% discount, already a healthy pretax gain.
Unfortunately, some employees fail to take advantage of their company's ESPP. If you are not participating, you may want to give your ESPP a second look.
Entry-level employees often opt out of their ESPP, notes Senseney. "But as they become more established in their careers and more financially secure, they should reconsider their ESPP. Depending on the discount your company offers, you could be passing on the opportunity to buy your company's stock at a significant discount."
Tip: Look at your current savings strategy—including emergency fund and retirement savings—and consider putting some of your savings in an ESPP. You may be able to use future raises to fund the plan without impacting your lifestyle.
Mistake #6: Failing to update your beneficiary information
As with your 401(k) plan or any IRAs you own, your beneficiary designation form allows you to determine who will receive your assets when you die—outside of your will. If you have made no beneficiary designation, under most plan rules the executor (or administrator) will, in fact, treat equity compensation as an asset of your estate.
Each time you receive an equity award, your employer will ask you to fill out a beneficiary form. Many grants range in life from 3 to 10 years, during which time many factors can change in your life. For example, if you were single when you received an option grant, you may have named a sibling or parent as the beneficiary. But 5 years later, you may be married with kids, in which case you would likely want to change your beneficiaries to your spouse and/or children. The same holds true if you were married and got divorced, or divorced and remarried. It's important to always update your beneficiaries.
Tip: Review your beneficiaries for your equity awards—as well as your retirement accounts—on an annual basis.
Next steps to consider
Visit the stock plan resources site.
Create your plan for retirement income.
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