The Hidden Costs of Stock Options: What You’re Really Paying
Starting a new company is an exciting time – New people, new things to learn, and lots of new income opportunities!
One of the benefits some companies provide is the ability to purchase stock at discounted prices. These stock options can be a great way to add to your portfolio, but what do they really cost you?
The truth is that there are some hidden costs that you might not anticipate. These go beyond the mere financial cost, though the exercise price plays a role. Here’s what you should know about what your stock options will truly cost you at the end of the day.
Exercise Price
When it comes to your stock options, the agreed-upon price is the first and most significant cost you’ll have to contend with. Your employer may offer a reasonable price for owning this type of security as part of your compensation package (or after a vesting period). However, that doesn’t mean that your initial investment in the security will be inexpensive.
Depending on the amount of stock, it can add up to a significant sum! It may not be an especially liquid investment, either – those funds will likely be locked down for a while while you hold and wait for the market price to rise. Make sure that you can afford to part with this money until then.
Taxes
Everyone fears upsetting the delicate balance they maintain with the IRS. Taxes can be a complex issue that requires your attention to maximize your finances. With taxes in the picture, it can be a financial cost as well as a mental one while you try to figure out the best way to keep as much in your pocket as possible.
The two main types, Incentive Stock Options (ISOs) and Non-statutory Stock Options (NSOs), have very different tax rules.
Incentive Stock Options (ISOs) receive more favorable tax treatment, but the rules are stricter.
At Grant: You are not taxed when you are granted the options.
At Exercise: When you exercise your options (purchase the shares), you do not owe any regular income tax. However, the difference between the stock's Fair Market Value (FMV) and the strike price is considered a preference item for the Alternative Minimum Tax (AMT). This "bargain element" could trigger the AMT, potentially leading to a significant tax bill for the year you exercise, even if you haven't sold any shares.
At Sale: If you hold the shares for at least two years from the grant date AND one year from the exercise date, your entire profit is taxed at lower long-term capital gains rates (known as a qualifying disposition). However, if you sell the shares without meeting both of those holding period requirements, part of your gain will be taxed as ordinary income, and the rest as a capital gain.
Non-statutory Stock Options (NSOs) are more common and have simpler, though often less favorable, tax rules.
At Grant: You are not taxed when you are granted the options (unless they have a readily determinable market value).
At Exercise: When you exercise your options, the "bargain element" (aka the difference between the Fair Market Value and your strike price) is instantly taxed as ordinary income. Your employer will treat this as compensation, so it will be included on your W-2 and is subject to federal and state income tax withholding as well as payroll taxes.
At Sale: When you eventually sell your shares, your cost basis is the Fair Market Value on the day you exercised them (since you already paid income tax on that value). Any profit you make above that basis ((Sale Price−FMV at Exercise)) is taxed as a capital gain. This gain will be short-term or long-term, depending on how long you held the shares after exercising them.
Opportunity Cost
Another cost of stock options is the potential loss of opportunities. Before you invest heavily in your stock options, make sure to consider how hard your money will work in this particular investment compared to other possibilities.
For some employees, stock options may be one of the best ways for them to potentially profit in the months and years ahead. If you work for a major tech company, you might expect stock prices to soar as new products and services become available.
However, investing those funds in options means they can’t go toward something else, like another investment, like real estate, launching a business, or diversified assets for your portfolio. This is your opportunity cost. Could the funds you spent on stock options be doing more work in a different type of investment? Are you putting yourself at too much risk with a concentrated stock position?
Work with a financial advisor to see how you can make your money work harder for you and create a more lucrative financial future. Sometimes, stock options may be the right move if you are already maxing out other investments like a Health Savings Account or retirement savings in the form of a 401(k) or IRA. In a different situation, these other investment vehicles may be the better fit.
Job Restrictions
Generally, stock options are subject to a vesting schedule. This means that in order to take advantage of your stock options, you may be forced to stay at your current job for months or years until those options become available to you.
This may not be a downside for everyone, but it’s still a major aspect worth considering.
Staying where you are might not be a big issue if you like the company and your role within it. But any number of factors could change your job satisfaction over the coming years, leading to burnout if you’re overworked or unhappy with those changes.
What if an exciting new job opportunity comes your way? Your stock options may feel like golden handcuffs.
Tips to Make the Most of Your Stock Options
With all of this in mind, how can you plan to make the most of your stock options? The good news is that there are a few steps you can take to ensure that investing in stock options is the right fit for you.
Read the entire stock option agreement. This stock option agreement provides all the details regarding the price at which you can purchase, how long you have to stay with the company, and when the option expires. Every detail you could possibly want to know about this move is in the agreement.
Remember the risk. As with all stock, stock options are not guaranteed and you could still lose your investment. Ensure that your portfolio is diversified. Refrain from making major financial decisions based on potential value. Wait until you have cash in hand before spending that stock value on something big.
Ask a knowledgeable professional. As always, the best way to ensure that stock options are the right move is to consult with an experienced financial advisor. Have them look over the stock option agreement, assess the rest of your portfolio, and allow them to make recommendations for your next steps.
Still Scratching Your Head? Let’s Chat.
When you want professional support while navigating the unique compensation structure of the major tech companies, Consilio is here to cut out the jargon and explain the basics in a way you understand.
If you’re dreaming of financial freedom, we can help you make it happen! We offer fiduciary services and wealth planning to help you make the most of stock options, RSUs, bonuses, and more. Give us a call and let's chat!
Disclosures
The information provided in this article is for educational and informational purposes only and does not constitute investment advice and should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status, or investment horizon. You should consult your attorney or tax advisor.
The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
Consilio Wealth Advisors, LLC ("CWA") is a registered investment advisor. Advisory services are only offered to clients or prospective clients where CWA and its representatives are properly licensed or exempt from licensure.
