UNDERSTANDING OPTIONS From the ‘ and Harvest’ Strategy to the ‘Capital Loss Whipsaw,’ here’s what you need to know about options.

By Monte Marti, CLU®, ChFC®, WealthStone Financial

If employer stock options represent a significant portion of your wealth, then you should proceed with care. A good employee stock can help you with your plans. But a poor strategy can squander assets and leave you saddled with tax obligations.

This white paper sheds light on how to manage your stock WealthStone Financial options. While a financial advisor can help you determine when to harvest profits from your options — and we recommend consulting with appropriate specialists — WealthStone Financial having a basic understanding of options can help you to make smart decisions.

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OPTIONS BASICS THE LINGO Many people receive stock options from their company. Since they are often granted to employees rather than STOCK — a contract where the option’s holder, requiring cash to obtain, you may not think of options as under certain conditions, has the right to buy or sell a stock you do traditional that require funding. Yet, for a set price. $100,000 worth of options can be just as important to your Exercise Price — the fixed price at which purchase or sale of stock can be made, usually equal to the market price financial well-being as an of $100,000 in , of the stock on the date the option is granted. bonds and mutual funds. Thus, it is important to implement Call — an option that gives the holder the right to a stock options strategy that balances risk and return, purchase stock at a specified price. enhancing after-tax profits and minimizing the potential for Date — the last day on which an option can be exercised to buy or sell a stock at the exercise price. loss. Vesting Schedule — the time that must lapse before an What is a Stock Option? option can be exercised by its holder. Intrinsic Value — the amount of profit to be made by A stock option is a contract. It gives the option’s holder, exercising an option to buy or sell stock. It is the spread under certain conditions, the right to buy (and sometimes between the market price for the stock and the exercise price of that stock. sell) company stock at a fixed price — the exercise price Time Value — the value of the opportunity to continue or . Usually, the exercise price is set to be the holding an option in excess of its intrinsic value. market price of the stock on the date the option is granted.

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Options are valuable. When the market price of a stock The vesting schedule refers to the number of years that rises above the option’s exercise price level, for example, an must lapse before all the options can be exercised by the option holder can profit. He can purchase the stock at a cost options holder. The vesting schedule is similar to the vesting below the prevailing market price. treatment of an employer’s matching contributions to a 401(k) plan. Five-year vesting schedules are typical. Two common features of an employee stock option are the expiration date and vesting schedule. The expiration To exercise an option, the holder provides the company date is the last day on which the option can be exercised. It with a notice of exercise and payment for the amount of is the last day when the stock can be bought (or sold) at the stock at the exercise price. Some companies allow their exercise price. It is common for options to expire 10 years employees to use company stock they already own to pay after they have been issued, though some employee stock the exercise price. Some people obtain a loan to exercise the options are issued for shorter periods, such as five years. option and cover any associated taxes and fees. They repay You should read your company’s employee stock options the loan when they sell the acquired stock. program benefits carefully. Many companies require that options be exercised within a certain number of days after terminating , or else they become worthless. You should read your company’s employee stock options program benefits carefully.

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Who Issues Them? What is the Benefit of Receiving Stock Each company sets rules for its stock options program. It Options? decides how many options will be granted, sets the exercise The opportunity to profit. Options earn financial gains if price, determines the expiration date and vesting schedule the stock price appreciates from the time the options are and decides other program features. awarded. Consider an example.

Each recipient of a stock option grant is given the rules. Let’s suppose, hypothetically, that a company is a leader in The expiration date should be clearly stated when the supplying electronics and communication technology to 1 options are awarded. Most recipients receive their options the aviation industry. At the beginning of the 21st century, with time to exercise them, but note that some options the avionics company goes public and sets up an employee terminate when the holder leaves the company. While some stock option program. Within a few years, the company’s companies allow a grace period for option holders who stock price more than quadruples in value. end their employment, giving them time to exercise their options, this is not a universal practice. Bear also in mind Suppose that an employee receives company stock options that certain events, such as a corporate merger, can trigger with a $40-per-share exercise price. Suppose, further, that an early expiration of any outstanding stock options. the employee’s options eventually become fully vested and,

1 This example is provided for illustrative purposes only and is not intended to reflect any actual company or situation.

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in this example, the avionics company’s stock reaches $70 a Stock Options and Your Taxes share. By exercising the $40 strike price, the employee buys Of course, exercising options and reaping results profits company stock at a huge discount. He pays $40 for shares will create a taxable event. So, before exercising options, it that trade on the market at $70. If the employee sells the is important to talk to a financial advisor or a tax specialist. stock shortly after acquiring it through his option, he profits Such professionals have devised strategies to help options $30 per share. (The actual net profit would be slightly less holders have sufficient funds on hand so they can than $30 a share due to transaction fees). exercise their options, buy the stock and pay any taxes that may be due. The above example illustrates what it means to be “in the money” with stock options. Being “in the money” occurs Most stock options are non-qualified. Exercising a non- when the current market price for a stock exceeds the qualified stock option creates a taxable event. Depending strike price of the option to buy that stock. on the gain made by exercising some options, buying stock, selling that stock and netting the proceeds, you may jump Yes, options provide financial flexibility and may improve into a higher income tax bracket for that tax year. your financial wherewithal greatly. They may help increase your cash reserves, pay off , fund retirement accounts, The tax obligation is incurred in the tax year when the fund your children’s college education programs and serve option is exercised. The obligation exists even if the stock as down payments to buy property. purchased is not sold during the same tax year. The amount

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of tax owed depends on many factors, and professionals should be consulted. But the key number is the spread or In the avionics company example, the option to difference between the current market value of the stock purchase stock at $40 per share, when the stock and the exercise price provided by the option. sells for $70 a share on the day the option is exercised, creates a $30-per-share spread. In the avionics company example noted above, the option to purchase stock at $40 per share, when the stock sells for $70 a share on the day the option is exercised, creates OPTIONS STRATEGIES a $30-per-share spread. This is considered by the IRS to be Proper timing is important when exercising options and immediate gain. It is considered income in the year the selling appreciated stock. This section explores the financial option is exercised, and is generally taxed as employee and tax implications of the “Exercise and Harvest” strategy. It compensation. Withholding is required for current provides a framework for deciding when you should apply employees. Income from the transaction will be included the strategy. in the employee’s Form W2.2

Exercise and Harvest It is common for people to exercise stock options, buy stock 2 Tax information is provided for educational purposes only is based on our understanding of current tax law is not exhaustive and is subject to change. and immediately sell some or all of the stock for a profit. It is important to work with an experienced tax professional for your unique situation as Securities America representatives do not offer tax services. This is known as a “harvest.” Harvest transactions provide

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immediate cash. They can reduce your exposure to certain Adjusted Basis Price kinds of risk by immediately locking in gains. The “Exercise and Harvest” strategy might appear to be a single transaction, since the exercise of stock options and Let’s suppose, hypothetically speaking, that you are an subsequent sale of the stock seemingly happen together. employee of the hypothetical avionic company mentioned But the IRS sees it differently. The IRS treats “Exercise and earlier. You hold 2,000 call options. The options offer a $30- Harvest” as two transactions: (1) the exercise of a stock per-share spread between the strike price and the current option and (2) the sale of stock. You will receive Form W2 market price. If you exercise these options simultaneously, that shows income (compensation) and Form 1099B that buying and then selling all shares of stock, your gain reports the stock sale. is $60,000 (2,000 shares x $30 a share) less expenses associated with the transaction. You incur taxes on the Even if you hold the shares and sell them at a later date, $60,000 gain. But your take-home is substantial. You can use you will not face double taxation for the gain in value of the net profit after taxes to make further investments, pay appreciated stock. This is because the IRS lets you calculate down some , make a large purchase, etc. your gain (or loss) after exercising your option using an “adjusted basis price” for the stock. You paid income tax Having long-term goals and a comprehensive financial plan upon buying the stock at a below-market price. But, in the can help you decide what to do with the money. future, you will be treated as if you bought the stock at that higher market price and not at the exercise price.

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To illustrate the point, suppose you paid $8,000 to exercise an option. After selling the stock you report $12,000 as A capital loss whipsaw occurs when you receive compensation in connection with the transaction. Your unfavorable tax treatment on both ends of a basis for the shares is $20,000. You pay income taxes on the transaction. $12,000 gain. If you sell the stock later for $24,000, you will have a capital gain of $4,000 at that time. Your overall profit But this $3,000 limitation creates the possibility of a is $16,000 ($24,000 - $8,000). But, you already paid tax on capital loss whipsaw. A whipsaw occurs when you receive $12,000 of compensation. This basis adjustment prevents unfavorable tax treatment on both ends of a transaction. double taxation. It is not unusual for stock values of fast-growing companies Capital Loss Whipsaw to be volatile and create this type of situation. The whipsaw Of course, holding any stock can lead to a loss — if the occurs if you exercise a non-qualified stock option and sell value of the stock drops — and this has tax implications, the stock later at a lower price. Suppose you paid $10,000 to too. Taxpayers are allowed to deduct capital losses up to exercise an option for stock worth $50,000. You would have the amount of any capital gains, plus $3,000. If capital losses to report $40,000 in compensation and pay income taxes. exceed $3,000, then excess losses can be carried over to subsequent tax years. Suppose then that a year later you decide to sell your stock, but the price has dropped and you receive only $29,000.

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You would have a capital loss of $21,000 ($50,000 - $29,000). exercising an option to buy or sell company stock. It is the However, due to tax regulations, you would only be able to spread between the market price for the stock and the deduct $3,000 of the loss per year. (This assumes that you do exercise price of that stock. If you own a stock option to not have any long-term gains that you are either offsetting purchase stock at $40, and the stock is currently trading at or carrying forward.) Not being able to deduct the total loss $70, then you have an intrinsic value of $30 per share (less in the year that it is incurred, or possibly even over your transaction costs). lifetime, because of the amount relative to the $3,000-per- year limit, may turn out to be an unfavorable tax event. Time value, on the other hand, is an abstract concept. It is the value of the opportunity to continue holding an option. So, preventing a capital loss whipsaw is important. It is one Time value is crucial, and financial advisors try to weigh reason why many investors choose to harvest profits by it carefully. For one thing, you have the opportunity to selling stock right when they exercise their stock options. participate in the growth in value of a stock, even though you do not have to pay for the stock until you exercise your Determining Value option. This delay in payment acts like an interest-free loan. The value of a stock option generally has two components — intrinsic value and time value. Each plays a More importantly, you have the potential for unlimited role in determining when options are ripe for harvesting. upside gain in stock price, but a limited downside if the Intrinsic value is the amount of profit to be made by price falls, so long as you hold onto your option.

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To illustrate, imagine an option with an exercise price of $16 They feel they can obtain a bigger profit by waiting. However, and the stock valued at $18 a share. If the stock value rises many employees overestimate their ability to predict their by $10, the option holder is looking at an additional $10 per company’s stock performance. share in profit. If the stock price falls below the $16 exercise price, then the option becomes worthless, but that is the Another method involves exercise and harvest based on extent of the option holder’s losses. Someone who owns the personal needs. You exercise options and sell stock when stock stands to lose more if the stock price keeps falling. you remodel your home or when your child’s college tuition bill arrives. The exercise-and-sell-the-stock-now approach Other things relate to time value. Having time to make puts money in your pocket and protects you against decisions increases the value of an option. Drawing near to possible loss of stock value. the option’s expiration date decreases its value. Still, holding options for as long as possible can be When to Exercise rewarding if the underlying stock price keeps rising. The Option holders and their advisors use many approaches to problem is no one can accurately predict future stock prices. determine when to exercise options. A common method And if a stock is had a steady run in price for some time, involves assessing how a stock is likely to perform. then the risk of holding an option might exceed the risk Options holders who think that their company’s stock of losing out on further gains to be made if the option is price will increase typically delay exercising their options. exercised.

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Some advisors take a rule-of-thumb approach. Instead of Given this uncertainty, it is wise to acknowledge the risk exercising options as soon as possible, or as late as possible, of holding too much company stock. You are not being the suggest holders exercise their options within two or disloyal to your company. If you have worked for your three years of the expiration dates. company for a long time and have accumulated a great deal of company stock and stock options, it is good to create a financial plan that can reduce your risk. OWNING STOCK IN YOUR EMPLOYER Many advisors recommend that no single stock or stock One pitfall of good stock option planning is the mistaken option program comprise more than 20% of a portfolio. belief that a stock performs well when the company’s Add up the following elements: business is doing well. Unfortunately, the stock price of an individual company is hard to predict. Time and time again, »» Value of stock held in your employer companies meet and exceed analysts’ earnings expectations »» Value of unexercised options in your employer only to see their stock price stagnate. »» Amount of stock your employer has used to match your 401(k) contributions

Whatever the cause, a company’s stock price can be volatile Together, these elements should not exceed 20% of your even when its operations are performing well. invested assets. If company stock and stock options exceeds that threshold, consider re-balancing your portfolio.

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Balanced Asset Allocation your risk increases significantly as the stock prices increase. In general, investments that have the potential for greater Suppose the hypothetical avionics company, mentioned returns also carry a greater risk of decline. A prudent earlier, saw its stock price rise from $20 per share to $70 per investor balances investments with growth potential (but share within a five-year period. Though the stock seemed higher risk) with investments with less growth potential (but lower risk). Many financial advisors recommend that no single stock or stock option program should

It might seem that the best thing to do is to make ultra-safe comprise more than 20% of a portfolio. investments. U.S. Savings Bonds and Certificate of Deposits are examples of investments that carry little investment risk. The problem is these investments provide so little growth strong, most financial advisors would consider a portfolio that they can lose significant ground to inflation. Investors loaded with this stock too risky. An employee with 30% to 40% should consider many kinds of risk and plot a course based of his nest egg invested in the stock takes a risk, especially on their goals. since the stock has already experienced appreciation. He should rebalance the portfolio. Will the re-balanced When the stock market is doing well, it’s likely that your portfolio outperform one invested heavily in one stock? company’s stock will share in the gains of the market. But if No one can say. But, the risk of betting too heavily on one you have too much of your wealth in your employer’s stock, company is high.

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Concentration Risk non-qualified stock option, the stocks you receive are taxed If stock options represent a large part of your portfolio, as ordinary income. Because you own the stock, you must you may face concentration risk. The value of your options come up with funds from your savings to pay the taxes. But, depends on the performance of their underlying stocks. If if the stock is held for more than a year before being sold, options represent only a small fraction of your wealth, and it can be taxed at a long-term capital gains tax rate, rather your wealth is otherwise well diversified, concentration risk than as ordinary income. may not be an important factor in your strategy. Exercise and Hold?

How you balance your risk depends on many other Therefore, some have observed that they can reduce their factors, such as your risk tolerance, short-term and long- tax obligations by exercising options early and holding term financial obligations, and time frame for using your stock as it climbs in value. Although superficially appealing, money. But by exercising your options, selling the stock and this “Exercise and Hold” approach has its drawbacks. It converting the gain into cash, you can deploy the proceeds abandons any remaining time value in the options. It could among a well-diversified portfolio of investment offerings. also expose the options holder to possible economic loss if This proves to be less volatile in the long run. the underlying stock price drops below the exercise price.

As suggested previously, the tax implications related to The strategy also exposes the options holder to the options are often misunderstood. When you exercise a possibility of a capital loss whipsaw if the holder reports

Understanding Stock Options www.WealthStoneFinancial.com      14 more than a small amount of income in connection with CONCLUSION the exercise of options. The strategy to exercise options and While options have some unique attributes, view them as then hold the stock works only for those who have a great you would any investment. You and your financial advisor deal of wealth. Such persons can afford to make the stock should periodically review the options you have and their purchases and cover any resulting taxes and fees. vesting schedules, strike prices and expiration dates. Look for opportunities to take advantage of increases in the value In contrast, many people choose to delay exercising an of your company’s stock, as well as the best time to exercise option to delay paying taxes. This is a legitimate approach. an option and minimize its tax impact. Delaying an exercise of options can produce a genuine tax benefit, so long as the benefit is large enough to justify the Realize that even if you have options in a company’s stock risk of the option becoming worthless. that has done well for several years, the future is uncertain. If the value of your options represents a significant amount If stock options expose you to only modest risk and of your total assets, it might be time to rebalance your are part of a balanced portfolio of investments, take tax portfolio and reduce your exposure to risk.  deferrals into account when determining whether to harvest or not. But if your risk level is unacceptably high, then it may be prudent to exercise your options. Paying taxes sooner rather than later is the price to pay to lower your risk.

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ABOUT THE AUTHOR An accomplished marathon runner, Marti has completed the Boston Marathon, the New York City Marathon and many Monte Marti, CLU®, ChFC® other races. Marti spends time working in his apple orchard, A former commodities trader, Monte S. Marti is President coaching his children's sports teams and volunteering in the of WealthStone Financial. He is a Registered Representative community. He lives in rural Mount Vernon, Iowa, with his with Securities America, Inc. and a Financial Advisor for wife, Mollie, and their three children. Securities America Advisors, Inc. WealthStone Financial WealthStone Financial (www.wealthstonefinancial.com) is a financial services firm based in Cedar Rapids, Iowa. The company is dedicated to helping clients plan for a lifetime of wealth fulfillment and provides insurance reviews, income distribution strategies, reviews, tax planning strategies and more.

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Tax information provided herein is based on sources believed to be reliable but not guaranteed and is subject to change. Tax and legal services are offered in conjunction with quali- fied professionals.

Securities offered through Securities America, Inc., member FINRA/SIPC. Monte S. Marti, CLU®, ChFC®, Registered Representative. Advisory services offered through Securities America Advisors, Inc. Monte S. Marti, Financial Advisor. WealthStone Financial, Inc. and Securities America companies are unaffiliated. Securities licensed in AL, AR, AZ, CA, CO, CT, FL, IA, IL, IN, KS, LA, ME, MI, MN, MO, MT, NC, ND, NE, NM, NY, OH, OR, PA, SC, SD, TN, TX, UT, VA, WA and WI. Insurance licensed in AZ, CA (Lic. # 0F04345), FL, IA, IL, IN, ME, NE, NV, PA, TX, and WI. Advisory licensed in IA and TX.

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