Welcome to the 5th edition of the Tech Financial Planning Newsletter.
I see it too often, and you can avoid it.
The number one mistake I’m seeing people make with their stock options is
Exercising all at once
In this newsletter we will cover the consequences of exercising all at once, how to avoid it, and some tips on better managing your stock options.
TL;DR
Most people exercise all at once because they haven’t planned for their options
Exercising all at once can create a “tax bomb.”
Being proactive and having a strategy can save you a lot of time and money
Why People Exercise All At Once
I usually see one of two situations.
The most common scenario is that someone leaves their job.
When that happens, they typically have 90 days to exercise their options, otherwise they expire.
The other is that a company either just went public or is about to, so people get excited and make a big exercise.
Here’s why this can be problematic.
1) You will probably pay more in taxes than you needed to
Let’s take an example where you decided to leave your job.
Like I mentioned before, most companies allow former employees 90 days to exercise their remaining stock options.
And most of the time, they still have most (or all) of their options left.
Depending on whether you have incentive stock options (ISOs) or non qualified stock options (NSOs), you might be creating a tax bomb for yourself.
For the sake of brevity, I won’t go into how the different ways stock options are taxed, but know this:
If there’s a big difference between the price you pay for your options and what they are currently worth, and you exercise enough options, you could owe a ton in taxes.
For example, if you pay $50,000 for shares that are worth $500,000, you probably have a 6 figure tax bill.
2) With incentive stock options, beware of AMT
When you exercise incentive stock options, technically no income tax is due.
But you could trigger the Alternative Minimum Tax (AMT).
And I’ve yet to see a situation where a platform like Etrade or Carta gives a clear warning about AMT when you exercise.
So what happens is people exercise their options and think they did their job.
They paid the cash and think everything is good to go.
Then next April comes and they find out they owe a huge amount of money.
3) With non qualified stock options, your company might not withhold enough in taxes.
When you exercise NSOs, the difference between the price you pay and what they are worth counts as taxable income.
Most companies will withhold / “charge you” 22% in taxes.
Example time.
You have 10,000 NSOs at $20 / share and today they have a fair market value of $50 / share.
So that means you have $300,000 in taxable income if you exercise all at once.
Taxable Income = # of options exercised X (FMV - Exercise Price)
Taxable Income = 10,000 X ($50 - $20)
Taxable Income = 10,000 X $30
Taxable Income = $300,000
Back to our example - your company makes you pay 22% in taxes.
But if you are in the 32% tax bracket and your company is only withholding 22%, you will have to make up that missing 10% come tax time.
Your employer “charges” 22% tax at exercise = $66,000 ($300,000 x 22%)
Your actual tax bill = $96,000 ($300,000 x 32%)
Potential taxes still due = $30,000 ($96,000 - $66,000)
4) You might need a lot of cash
You need to consider the true cost of exercise.
By true cost, I mean both the cost to purchase your options and the cost to pay your tax bill
Sometimes there are options to sell to cover or do a cashless exercise.
But let’s say you trigger AMT or your company didn’t withhold enough in taxes.
That’s a tax bill that still needs to be paid.
Come next April, you will need to come up with a bunch of cash
5) If your company is private, you might have no way to sell the shares to pay the tax bill.
Candidly, this is a brutal scenario.
You’re at a private company and you exercised a bunch of options.
You find out you owe $100k + in additional taxes.
Now you have to find a way to pay for it.
And because your company is private, you (probably) can’t sell your shares to cover the cost.
6) It can be stressful
Particularly if you just left your job.
Reminder, if you leave your company, most options expire after 90 days.
That’s roughly 3 months to make some big decisions.
Meanwhile you are changing jobs, trying to get acclimated, taking on new responsibilities, etc.
While figuring out what to do with your options.
It can be a lot!
There can be a better way
Well, the opposite of exercising all at once is, you guessed it…
Having a plan
I’ve found that, when done correctly, people could have saved thousands (or tens of thousands) in taxes.
If they were proactive.
Here’s some things to consider.
1) Spread out the exercise
When you exercise all at once, you create a potential tax bomb.
Because you are creating all this extra taxable income (or for AMT, bargain element).
But if you can be more strategic, you can lessen the total taxes.
For example, with ISOs, you can exercise “just enough” so that you don’t trigger AMT.
And with NSOs, you can exercise “just enough” so that you don’t jump into higher tax brackets.
If you do this over several years, you can exercise a big bunch of your options but pay a lot less in taxes.
2) Figure out how to pay for it all
If you’ve figured out the total cost, and you know you won’t have the cash necessary, you can start looking for other options.
Here’s some ideas:
Leverage a 3rd party like Equity Bee or ESO Fund
Take a personal loan
Get help from family
Take a 401k loan
Look at other investments (ie margin on other stock, cash out refi or HELOC on a house)
Some of these are riskier than others! So please make sure you are working with someone to consider all the options and potential risks.
3) Or plan not to exercise
Because it can make sense not to exercise too!
I met with a client recently.
He works at a private company and just hit the 1 year mark.
His first bunch of incentive stock options (ISOs) vested.
We decided not to exercise them right now because he’s getting married next year and his company is a long way from going public.
He has a lot more important needs for his cash and there’s a good chance these shares won’t ever be worth anything.
He’s not about to leave the company.
But if he was, we would revisit the conversation and see if he wants to exercise some.
How we work with clients with stock options
This is where art meets science.
The art is understanding our client’s dreams, their ability to take risks, and what they are looking for.
The science is working through how many options, the taxes associated, and how to pay for it all.
One of our main objectives is to be proactive!
When it makes sense, let’s start exercising early.
Let’s minimize the total tax bill.
Let’s make sure we know the taxes and have the cash set aside to pay it.
If your company is public, let’s talk through when we will sell.
For some people, it’s worth it to take a little more risk.
For others, it makes sense to diversify into other investments or fund their goals.
But to put it all together, we are getting ahead.
Wrapping Up
It’s really easy to make mistakes with your stock options.
And your company isn’t in the position to help you make education decisions.
If you have significant equity compensation, consider getting the help of professionals, both a financial planner and a tax preparer.
They will help you make the most of your equity compensation while minimizing mistakes.
If you don’t have someone on your team, I’d be happy to chat.