Stock Options and Restricted Stock – Key Things to Consider In this Downturn
If you are an executive working for a public company, it’s likely that a big portion of your wealth is tied to your company stock. As stock prices fall, obviously the value of your stock-based compensation also drops. This can be paralyzing. Amid the chaos, how do you answer the simple question: “what should I do now?”
Executive compensation includes many components, including stock-based compensation. Two of the most common we see are stock options and restricted stock. Today we’ll focus on those areas, as well as some key strategies to consider.
What are they?
Stock options are the right to buy the company’s stock at a specific price over a set period. They normally have a stated expiration of 10 years. The following chart helps illustrate the concept:
The above example shows options that are in the money. The challenge is in a declining market, your stock price can fall below the grant price. If that happens, your options are underwater. If they stay underwater and expire, you end up with nothing.
What to do?
1. Understand how dependent your financial plan is on these options (and all of your stock-based compensation for that matter). If you haven’t had a plan done before to assess this, you should.
If your options are in the money and nearing expiration, you may want to consider exercising them sooner versus later – especially if your plan depends on them. On the other hand, if you don’t depend on them to meet your goals, then you have more flexibility to roll the dice.
Of course, if they are out of the money (i.e. underwater and worthless), then all you can do is wait.
2. Don’t let the tax decision drive the investment strategy. Taxes should always be analyzed, but they shouldn’t be the driver. For non-qualified options (most common), they generally are taxed upon exercise. Incentive Stock options have a holding-period requirement to get preferential tax treatment. But if the stock falls and never recovers, taxes won’t make a difference.
3. Understand the leverage component in stock options. Leverage means the value of your options increases or decreases more in percentage terms than the stock itself. Therefore, shifts in stock price have a dramatic effect on your option value. If you are looking to maximize the upside, hold your options. Leverage works the other way too, so if you are looking to protect the downside, review your options first.
Restricted Stock Plans
What are they?
There are generally two types. Restricted Stock Units (RSUs) are a commitment to transfer shares or cash to you at vesting. You don’t actually receive the stock or dividends, and there are no special elections. You receive them at vesting and they are taxed on the fair-market value at that time.
Restricted Stock Awards (RSAs) are a little different. You actually receive the stock on the grant date, subject to certain provisions and restrictions. You may receive dividends and also have the option to make a special 83(b) election, which allows you to pay tax at the time they are granted versus down the road when they vest.
What to do?
Why would you ever pay tax early? If the stock is depressed, then you pay tax on a much lower value with the 83(b) election. Of course, that assumes the stock goes up later. Again, this is only available on RSAs and not RSUs.
For RSUs, an effective diversification strategy is to sell the stock as soon as it vests and then reinvest the proceeds. Why? There is no additional tax to pay on that day if you sell because the basis on the vesting date equals the value. Therefore, your gain is essentially zero. If you hold on and it increases further, the gain from that point on is capital gain.
With the right planning and information, you can make the most of your stock-based compensation. As you can see, there are many complexities and moving parts.
Realize with any strategy, there are always tradeoffs. We strongly recommend consulting a qualified advisor before taking action, and to help you decide what is right for you.
No representation is being made that any strategy shown will or is likely to achieve results similar to those shown in this presentation. BDF does not provide legal, tax, insurance, social security or accounting advice. Clients of BDF should obtain their own independent tax, insurance, and legal advice based on their particular circumstances. The information herein is provided solely to educate on a variety of topics, including wealth planning, tax considerations, insurance, estate, gift, and philanthropic planning.
Gary K. Pattengale, CPA, CFP® is a Wealth Manager at BDF and is a member of the Firm’s Investment Committee. With 20-plus years of professional experience, Gary began his career as a public accountant, training that he uses to help his clients minimize their tax burden. He draws on his extensive experience to provide his clients with strategic insight into the planning and investment strategies most suitable to their circumstances. Gary earned a BS in Accounting from Northern Illinois University as well as the Certified Financial Planner™ and Certified Public Accountant designations. He is recognized as a FIVE STAR Wealth Manager by Chicago magazine, and is a member of the American Institute of CPAs and Financial Planning Association.