EP Wealth's Regional Director, MJ Nodilo, AIF®, shares essential tips for managing employee stock options, from understanding tax implications to avoiding common misconceptions.

Essential Tips for People with Employee Stock Options

Employee stock options can be a valuable part of your compensation, but they can also be more complex than many people realize. Over the years, I have seen employees focus on the upside of the stock price without fully understanding how their options work or how taxes apply. The result is often that a decision gets made based on assumptions, and the tax outcome is surprising.

When managing stock options, preparation and education are key. You need to know what type of options you have, when they vest, when they expire, and how exercising them may affect your tax return. If you don't have that understanding, it's important to seek guidance from someone who works in this space. Relying on informal advice from coworkers can potentially lead to costly missteps, because everyone’s situation is different and what was appropriate for someone else may not apply to your circumstances.

Here are some of the key points I typically go over with my clients when strategizing around stock options:

• Not all stock options are the same, and different types carry different tax treatments
• Exercising stock options can create a taxable event even if you don't sell
• Employees should know every grant they hold, what it's worth, and when it expires
• “The stock will always go up” can be a risky assumption that may lead to taxes without gains
• Exercise decisions should be made as part of a broader financial plan, not in isolation
• Water cooler advice from coworkers is not a substitute for professional guidance tailored to your individual situation

7 Tips for Managing Your Stock Options

Tip 1: Give Your Stock Options the Same Attention You Would Give Your 401(k)

Many employees don’t look closely at their stock options until they receive an email from HR telling them a grant is about to expire. At that point, they're forced to make a narrow decision about one grant rather than taking a broader view of their full options landscape.

My advice is to understand all of your grants, what the exercise prices are, and when each one expires. When it comes to corporate benefits, most employees have a good handle on their 401(k), including how much it's worth and how it fits into their financial picture. But stock options and other equity grants often don't get that same level of attention, even though the complexity is greater and the financial impact can be just as significant.

Tip 2: All Options Do Not Work the Same Way

The assumption that all options work the same way is a common misconception, and acting on that assumption can lead to unexpected tax outcomes. There are two main types of stock options: non-qualified stock options (NQs), which are the most commonly granted, and incentive stock options (ISOs), which are often given to directors and senior-level employees. Each type carries a different tax treatment.

For example, ISOs can add to an employee's alternative minimum tax (AMT) liability in ways they may not anticipate. Before making any exercise decisions, make sure you know which type of option you hold and how it's taxed, otherwise you could trigger a tax liability you did not plan for.

Tip 3: "I Only Get Taxed When I Sell" Is a Common Misconception

Another widespread misconception is that stock options are only taxed at the point of sale. In reality, exercising options can create a taxable event on its own, regardless of whether you sell. This is one of the areas where I see people get caught off guard the most. The fact is that you could owe taxes in the year you exercise, even if you continue to hold the shares and haven't received any cash from the transaction.

Tip 4: Don't Assume Your Company's Stock Can Only Go Up

Employees often default to the belief that their company's stock is only going to increase in value - this is especially true in the technology sector - but this certainty can be misplaced. I saw this play out repeatedly in Silicon Valley during the late 1990s through 2002, when employees exercised their options, held the stock waiting for further gains, and watched it lose most or all of its value, while still owing taxes on the exercise.

A narrow focus or bias toward a single expected outcome is a real risk when it comes to stock options. Instead, consider how a decline in the stock price might affect both your portfolio and your tax position before moving forward.

Tip 5: Don't Make Exercise Decisions in a Vacuum

An exercise decision should be part of a broader financial plan, not a standalone event. Consider what other stock exposure you have to the company, how frequently you're receiving new grants or restricted stock units, and what your financial goals are.

This is especially relevant when it comes to concentration risk. Stock options are only one piece of your exposure to company stock. You may also hold restricted stock units, receive bonuses paid in company stock, and carry a significant amount of company stock in your 401(k). If you're going to be with the company for a long time and the company is generous with equity compensation, that concentration is likely to keep growing. Exercise decisions should be made with a view across all of these holdings, not just the options themselves.

If the goal is to reduce concentration risk, exercising and selling in one event may help accomplish that, but it needs to be considered thoughtfully within the context of a broader plan.

Tip 6: You Have the Option to Exercise and Sell Simultaneously

Many people assume that exercising an option always means purchasing the stock and holding it. They don’t realize they also have the option to exercise and sell in a single transaction, converting the option directly to cash.

Sometimes referred to as a “same-day sale,” this allows you to use the sale proceeds to cover the exercise cost and any taxes that may be triggered, rather than coming out of pocket. There are several reasons an employee might consider this approach: they may want to reduce concentration risk if a large portion of their income and net worth is already tied to their employer, they may need liquidity for a specific purpose, or they may want to avoid certain tax complications that can come from holding shares after exercise.

Whether this is the right strategy depends entirely on your individual situation, so it's important to talk through the specifics with an advisor who can help you weigh the trade-offs based on your financial picture and goals.

Tip 7: Don't Rely on Water Cooler Advice

One theme I’ve seen repeated when it comes to stock options is that employees will rely on a coworker for advice or make decisions based on the community consensus at the workplace. While these “water cooler” conversations may be well-intentioned, they often fail to recognize that every person’s situation is different. Option types, grant sizes, vesting schedules, income levels, and tax exposure can vary widely from one employee to the next. What worked for the person you have lunch with may not apply to you.

If you are unsure how your options work or how exercising them could affect your tax return, it makes sense to seek the help of a professional who has experience in this area. When evaluating an advisor, I recommend asking direct questions like: Do you regularly work with clients who hold stock options and other forms of equity compensation? What platforms or systems do you use to help employees evaluate exercise decisions and model potential outcomes?

Stock option decisions can have implications for taxes, diversification, and other areas of your financial picture, so it's important to work with someone who takes a holistic financial planning approach and can evaluate how each decision fits within your overall plan.

Be Prepared and Know What You Have

If there's one message I'd leave you with, it's this: be prepared and take the time to fully understand your options before you act on them. Know what you have, how each grant works, and how exercising could affect your taxes and overall financial plan.

If you need clarity on any of this, don't rely on informal advice from the person in the next office. Find someone with real experience in this space who can help you evaluate the tradeoffs before you make a move. A little preparation upfront can potentially help prevent costly surprises later.

Employees and executives who want to discuss how stock options fit into their broader financial plan can reach out to a financial advisor at EP Wealth.

We can help you evaluate your options, understand the tax implications, and build a plan that accounts for your full financial picture.

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