I recently exercised some Non Qualified stock options, and am struck again by the complexities of the decisions surrounding options. These complexities seem to be little understood by most, and if my experience is typical, there is little in the way of documentation/explanation to guide the holder. So, let me relate what I've learned about the rules regarding options and my experience concerning how it affects the decisions you must make. As always, comments from the experience of others is welcomed.
When options are issued, they seem innocuous enough. There is no immediate effect on your taxes and the value is zero. If the stock price does not increase, they remain valueless. However, if, as in my case, the stock price appreciates, it leads to a number of nice-to-have, but none-the-less perplexing issues concerning when to exercise them. These issues, and their effect on your decisions are outlined below:
1. The value of options is extremely volatile. Options are more volatile than the stock by a factor of the current stock price divided by the difference between the current and the strike price. In my case, that means the options are 3-4 times as volatile as the stock price, which of course is likely already considerably more volatile than, say, a stock index fund. If the value of the options is low and you are still working, this may be a small issue. But, once you've retired and the value grows to a significant percentage of your portfolio, this begins to create a significant risk, despite the fact that the volatility has a huge upside if the price appreciates significantly. Incidently, running a standard set of assumed appreciation will always mean you are far ahead to keep the options until the last minute due to the leverage, so you have to consider whether the risk makes this worthwhile.
2. Dividends are not rec'd. If dividends are a significant part of the long term total return of the stock, as in my case, the fact that option holders do not receive the dividends becomes a drag on the investment as compared to owning the stock. If the price appreciates substantially, the leverage mentioned above more than overcomes this problem, but if not, the options suffer relative to other investment options.
3. Taxes. The proceeds for the exercise of options are taxed as regular income, including social security and medicare. If you are still working and the deadline for exercising is far away, it may be wise to hold in hopes of being in a lower tax bracket by the time you need to exercise and it is hard to justify triggering these high taxes any earlier than necessary. But, if you are retired and approaching the deadline, holding them exposes any future increase to regular tax rates and SS and Medicare, as opposed to alternative deployment of the capital. Other alternatives, such as index funds, expose any future increase only to much lower capital gains or dividend rates and allows you to time even this taxation to your best advantage over many years. And, it avoids the SS and Medicare taxes altogether on future gains. But, that must be balanced against the tax hit today.
So, where does all this leave you? With a jigsaw puzzle!! Generally, if you can see yourself with a lower tax rate prior to exercise deadlines and the value/volatility is not too high, it probably makes sense to delay exercise. If, however, the additional risk is an issue, and your tax rates are more or less steady through the period before your deadline, you may want to exercise early to minimize taxes on future gains. Even if your rates are otherwise steady, you'll need to evaluate the amount to exercise each year to avoid pushing yourself into a higher bracket by virtue of the exercise. My answer to this is to use a copy of TaxCut software to run a plethora of cases. This exercise may surprise you, as it did me, prompting me to sell more early on than previously planned. With all the complexities it is almost impossible to arrive at the best option without using tax software, although the ultimate answer almost always depends on your conviction about the prospects for the stock. If you're sure the price of the stock will move firmly upward, you can laugh all the way to the bank while holding the options as long as possible. Just keep in mind that this is a two-edged sword. You could be crying all the way to the poorhouse if the stock drops.