At 62, Chicagoan Jim McCarthy has been enjoying an early retirement without as much of the typical worry about fashioning a “fixed” income that will guarantee his money lasts as long as he does.
What gives him financial breathing room: stock options earned during his 26-year career at Schaumburg-based Motorola Inc.
“I’ve been blessed,” says McCarthy. “The stock options have made a huge difference,” he says, referring to money he’s earned from options during his retirement and throughout his career.
Approximately 10 million American workers are now similarly blessed, because they receive stock options from their employer, estimates Corey Rosen, executive director of the National Center for Employee Ownership in Oakland, Calif. These 10 million are non-managers, adds Rosen, people with secretarial or customer service jobs, for instance.
Used to be, only upper-level managers qualified for stock options. But, over the last decade, about 20 percent of public companies have begun to offer all of their workers stock options, says Rosen. Many of these are large public companies with familiar corporate names that are also large employers in the Chicago area.
“The popular characterization of options in the media is of small, high-tech companies that give their workers options and then all the workers become millionaires when the company goes public,” says Rosen.
A more accurate portrayal of how most workers obtain options is through an established public company. While there is less chance of becoming a hugely wealthy “optionaire” when you are working for an established public company, options can still help you build significant savings.
Here’s how stock options put extra money in workers’ pockets: A company gives an employee options to buy a certain number of shares of the company’s stock in the future at a certain price, called the “strike price.”
It usually takes a few years before the options “vest,” or the worker can actually buy or “exercise” his options to buy shares at the designated strike price. After the options vest, workers typically have a few more years to decide when they would like to exercise, or buy the stock, before the options expire.
So, if you are granted an option to purchase 100 shares of the company’s stock at $20, and after three years your options vest, and the market share price of the stock is then $30, you could profit $10 per share, or a total of $1,000 (by buying the stock at $20 and then immediately selling the shares at $30).
Sounds like a simple matter. But experts say there’s a lot more involved, such as how to minimize taxes on option profits and exactly when to exercise. These questions have sent option-holders scurrying to professionals for advice.
“What I find is that people join a company and the options they get don’t mean much to them initially,” says Steve O’Hara, who as a partner with the Chicago-based Financial Strategy Network, specializes in option advice. “But then somewhere along the line they become aware that the options vest and they are anxious to sell.”
You don’t necessarily need to pay an accountant or financial planner for advice.
So that their workers understand options, many companies sponsor seminars on the subject. Although companies are legally prohibited from giving their employers personal financial advice, the seminars provide general guidelines, notes Freida Kavouras, a partner with Ernst & Young, Chicago, an accounting firm that conducts these seminars for employers.
In addition, a number of Web sites, such as www.OptionWealth.com, www.Stock-Options.com, and www. MyOptionValue.com, have been introduced.
Here, some of what workers and experts say on making the most of options:
– Your tax strategy depends on the type of options you hold.
Options come in two varieties: the incentive, or qualified option, and the non-qualified option. The central difference is how you’re taxed on the money you make from exercising.
With non-qualified options, taxes are fairly straightforward. Any profits are treated as ordinary income, and you’re taxed just as if you earned the money in your paycheck.
From a tax standpoint, holders of non-qualified options need to be aware of what the extra dollars will cost them overall. Even a little more in earnings could push you into a higher tax bracket, and you will be forced to pay a higher percentage of your overall income.
Nan Webster, who works for Pharmacia, recently attended an option-education seminar at the Skokie company, and is now keeping a mental tally of what her annual income is coming in at, so that she may make a better judgment on when to exercise.
The qualified options are more complicated and these really prompt employees to seek professional advice. For the most part, managers and executives receive qualfied options, and workers lower on the ladder get non-qualified options, but that is not a hard-and-fast rule.
If you’re careful to follow the rules, says O’Hara, any profit you make from incentive options can be taxed at the 20 percent capital gains rate, rather than at your income tax rate. But to get the favorable capital gains rate, you must hold on to the stock for one year after you exercise your options, instead of immediately selling shares.
Even if you do hold the stock, however, you may kick in a lofty “alternative minimum tax,” warn experts. It’s pretty complicated stuff, says McCarthy, who has had non-qualified options but now owns only the qualified variety. He checks in with his adviser regularly about when to exercise to avoid the dreaded alternative tax.
– It’s usually better late than sooner, but deciding when to exercise options is a personal choice.
Stock prices have gained over the long haul, so theoretically, the longer you hold on to your options, the better the profit you stand to make.
That’s the theory, but in practice many individuals have good reasons to cash out sooner, says O’Hara. If, for instance, you are planning to quit in several years, it makes sense to systematically cash in options each year. After you leave, explains O’Hara, you may be asked to exercise all your options within 90 days. If you wait until then, “you might be making thousands of dollars and trigger a huge tax,” says O’Hara.
– Beware of having too much wealth in one basket.
Since many companies issue options each year, O’Hara says he frequently sees people who’ve accumulated options on hundreds of shares.
“You want to take some of that money off the table and start to invest in something else,” he says. “You have to diversify. I had a client who had a lot of options, so I suggested he start exercising them. Two years later, his company merged and the stock went down 30 percent. If he hadn’t diversified earlier, he would have seen much of his wealth disappear.”
– If there’s profit potential, find a way to exercise.
Whenever the market price is higher than the strike price, it represents money available to the option-holder. Unfortunately, notes David Gumpert, author of “Better Than Money: Build Your Fortune Using Stock Options and Other Equity Incentives in Up and Down Markets,” some workers let their options expire unused.
At many public companies, exercising non-qualified options is a “cashless” transaction, notes Gumpert, meaning that employees can receive a check without ever having to put up any of their own money — the shares are simultaneously bought and sold and the worker gets a check.
If such a cashless transaction is unavailable, “it is worth getting a loan to exercise the options rather than let the money slip away,” says Gumpert.
