How can I optimize all this stock?

[Symbiotic]

Greetings all,

I am in the fantastic position of having a hard time figuring out what to do with a series of stock options in my company that are now vested and available for exercise. On the one hand, it really is a lovely problem to have. On the other hand, I don't feel like I have very many choices. I am curious if any of you can identify any strategies that I am missing.

I have about 100,000 options to purchase stock shares for pennies. Those shares are worth about $15 each on the market. I have another 50,000 that will vest over the course of the next few years, at roughly 2,000 per month. I also have restricted stock that will automatically vest every quarter over the same two years and at a similar quantity of about 2,000 per month. I earn about $250k per year of regular salary. I contribute the maximum to 401k and an HSA.

The restricted stock vesting events basically turn into immediate sales, and the income is treated as W2 -- as if I'd earned it in salary form. So it gets taxed fully-loaded at the high marginal federal rates, plus state, plus FICA. Not much I can do about that.

The existing options are just sitting there, and most can be held for another 3 or 4 years before I must exercise. If I exercise and sell immediately, I pay the same fully-loaded tax. If I exercise and defer one year, I pay AMT right away (at what amounts to a fairly similar rate) and then deduct that later when I sell and just pay the long term gains rate. Especially if I think the stock will not lose too much value, many would advocate exercising and holding. However, I ran the numbers, and it's really not that big a difference. At first glance, you'd think it would be the difference between the short-term gains rates (marginal federal) and the long-term gains rates (15%, currently)... but in fact, because of the way the AMT interacts with taxes on the rest of one's income, the real effective rate ends up close to 25% even after the AMT is credited back in a later year. (And, of course, it's no certainty that the LTCG rate will be so low in future years, which could make the savings even smaller.)

If I haven't spouted too much gobbledygook yet, there's more: even if I go ahead and exercise and sell all this stock as soon as I can (one plausible plan...), now I'm left with a whole bunch of cash that I need to manage in a taxable account. I don't think it's possible for my then-meager 401k to counterbalance my portfolio well enough just by putting the tax-inefficient holdings in the 401k and holding equities in the taxable. I mean, I have 220k in my 401k, and we're talking about something like 10x that (post-tax) over a couple of years.

If it helps, I'd like to stop working for pay in roughly 2 to 3 years. We can easily live on 4% or less of that portfolio size. So I will be reducing income considerably, and maybe that opens the door for some other strategies for tax management. (?)

Other than moving to a 0%-tax state, and possibly sending some big donations off to a donor-advised fund like Vanguard Charitable -- effectively bringing forward a bunch of future gifts while they deduct most efficiently against my high tax rate -- is there anything else I should consider in this scenario?

One last question: if the values tripled, so the total set of holdings was worth more like $6M pretax, would that change anything?

Thank you for reading!

 

[MichaelB]

Hi Symbiotic. I understand your situation but am not sure what your question is. I think you should just go ahead and exercise your options based on your financial plan, pay the taxes and then invest the money. Moving to a 0 tax state won't change your federal tax obligation. As to your final question, whatw changes is you'll have more money.

Good luck.

 

[2B]

The restricted stock just comes in when it does so that's really irrelevant to any decision process other than it increases that year's income. You are safely above the SS limit so your tax damage is at the a high marginal tax bracket for the feds and state plus the Medicare tax. I may be mistaken but I think charitable contributions are affected by the current AMT patch so the Vanguard Charitable donation may not work well.

As for the existing options, what percentage of your net worth does it represent? If over 10% (remember Enron), I suggest exercising and doing what you need to do tax wise. If not, what do you think the future of your company will looking like over the next five years? If solid, you will have more tax options after you retire. You may be able to avoid the AMT or it could go away completely in a more comprehenive (and needed) tax reform.

 

[MBAustin]

I'd be inclined to start locking in some of those gains regardless of the tax implications by exercising and selling and investing in taxable accounts (in a tax-efficient manner for those gains). The pace would depend on how solid you think your company's stock price is and as 2B mentioned, the percentage of your total net worth they represent.

 

[RockyMtn]

When I had restricted stock vest i would sell immediately and use the proceeds to diversify. Leaving too much in the company can lead to problems no matter how rosy the outlook might seem. Remember all those folks at Enron who got cleaned out?

 

[Lsbcal]

You should be aware of the financial problems people had in the tech crash. Some exercised their options with borrowed money and when the stock crashed they were left deeply under water -- because they kept the stock.

So I guess the lesson would be to not carry an undeversified portfolio that could wipe you out if that company experienced problems, even temporary problems that could cause you to sell in panic.

 

[RunningBum]

I also recommend locking in some of those gains so you can diversify. You've got a lot of eggs in one basket, and being on the inside of a company that's done so well, you may be blinded to some of the downside. I've heard some horror stories of people who have exercised and held, and didn't even put away enough for taxes, and then the stock tanked and they owed taxes, with no way to pay them.

In my case I believed my company was pretty bullet-proof, and while I sold some at nearly the high, I held onto too many options and watched the stock drop 90%. It's still only around 25% of the top value, and my failure to lock in kept me working for another 8 years. I was a bit greedy in hoping the stock would continue to climb, and also wanted to wait to cash more out when I moved to a state with 2% lower tax rate. I looked at that 2% difference as a really nice car I could buy, but when the bottom dropped out, I was kicking myself. My other issue is that I mentally equated exercising it all with retiring, and I just wasn't yet in a mental state to retire for another year. The reality is that they are two separate things and I should've exercised it all and then left whenever I was ready, while also vesting more options and collect a salary.

Some of the tax implications have to do with whether your options are NQ or ISO. I can't recall enough details but my understanding from 10+ years ago was that there were some ways to shelter ISO options, but not NQ. You just have to figure you're going to pay of lot of taxes on NQ options no matter what, and about all you can do is spread it out over a few years. Or you might even guess that the tax situation isn't going to get any better for high income people, so maybe sell a bunch this year. Without getting into politics, the November election may influence you, though really, I wouldn't let taxes sway the decision too much.

The nice thing in your case is that you still have options vesting plus the other restricted stock grants, so even if you exercise and sell all or a significant amount of vested shares, you still stand to profit well if the stock keeps moving up. The question you have to ask is whether holding tight and taking a shot at $6M is worth risking being financially independent now.

You might lay it all out with a tax accountant for an hourly fee and see if they have any advice. I didn't bother because other co-workers just said that for NQ shares, you'll pay the taxes and you just had to decide when to pull the trigger.

As far as taxable vs 401K, index funds are pretty tax efficient and if you want bonds in taxable, you can get tax-exempt bonds. Is that the kind of thing you were asking about? Sure, you'll pay some taxes on the income that account generates, but the good news is that the basis has been taxed, unlike the 401K/TIRA account.

Maybe too much rambling but you sound like you're where I was 11-12 years ago, and I could've done better than I did.

 

[Animorph]

When I suddenly had lots of company stock I compared it with stocks of other companies that I wouldn't mind owning. This was in 2001-2003, the big dip in the market. Which is actually a great time to sell company stock, since you will have less of a taxable gain. When the ratio of the stock price of my company over the stock price of the other company reached new highs I would sell my shares and buy shares of the new company. That way you are still fully invested, still own companies you like, and have sold high and bought low. When I finally gave up tracking my results I was up about 15% over just holding company stock, though YMMV a lot of course. It sounds like you don't have a choice in your timing for much of your shares.

I'd try to keep your income below the top of your current tax bracket if you can. And try for long-term capital gains. If you're already converting a bunch of shares each month there's not a big rush to sell those shares that you can hold for a year.

 

[RunningBum]

When I suddenly had lots of company stock I compared it with stocks of other companies that I wouldn't mind owning. This was in 2001-2003, the big dip in the market. Which is actually a great time to sell company stock, since you will have less of a taxable gain.

Hmm, great for taxes, not so great for overall gains.

And try for long-term capital gains. If you're already converting a bunch of shares each month there's not a big rush to sell those shares that you can hold for a year.

That doesn't work for stock options, at least not the NQ kind. When you exercise, you owe taxes at regular income rate for the difference between the current price and your option price. Your basis going forward is the current price, so you could only get LTCG on however much the stock goes up from that point.

 

[Danmar]

I faced the same issues although the tax treatment of option gains in Canada is more favourable. Timing of option cash outs is the major question. In my case I held them pretty much as long as I could although this resulted in gains being about $2mm less than optimal. In total I cashed out about $15mm pre tax. The advice given in previous posts is good. You might want to set up a monthly cash out program where you cash a fixed amount each month over some period. in our case we moved to a lower tax province which saved about $1mm in tax over the cash out period. You are right, this is a good problem to have.

 

[mh]

+1 on the sell them and diversify. The issue of the tax hit is less worrisome to me than the fact you 've got so much in one stock . If it was me I would sell at least half of it right away

 

[Animorph]

That doesn't work for stock options, at least not the NQ kind. When you exercise, you owe taxes at regular income rate for the difference between the current price and your option price. Your basis going forward is the current price, so you could only get LTCG on however much the stock goes up from that point.

He's got some ISO's if he's calculating AMT on exercise and LTCG on selling.

 

[FIREd]

The value of my stock options was so volatile that stock price was much more relevant to my decision to sell and diversify than the size of the tax bill. Sold some in 2010 at $15 a share. A year later, my options would have been worthless after the stock fell to $5 a share.

 

[Symbiotic]

You guys are great. Thank you for all the suggestions, and especially the stories from those of you who have been here before. I didn't really have any concrete questions, but instead am just fishing for advice and hoping I might have overlooked something interesting or valuable.

It sounds like you all in the aggregate pretty much feel like I do: screw the taxes, just start getting out of being so overweight in my own company. Being mildly OC and a tax nut, though, I can't help but try to figure out ways to incrementally minimize.

To close a few loops mentioned above, I have ISO, NQSO, and the RSUs -- a real alphabet soup of fun. But most of them are ISO, so I do have the choice to hold and gamble. I cannot sell on a whim; I have to schedule my transactions well in advance using a defined plan because of my position in the company. I also can't sell in big chunks, because it will move the market in the stock too much.

My experience with tax advisors has been pretty subpar, although I live in an area where there are very few people with my kind of situation, so I probably should go find someone good like Kaye Thomas. But he charges $500/hr, and I am a stingy bastard. I have had good fun learning BNA, which is an incredibly useful tool for multi-year planning.

Because of my company's business model, there is an intrinsic floor to its performance that basically guarantees that the stock will not do a giant nosedive. In fact, the opposite has happened -- the stock has priced up well above what I calculate using my more conservative model. On the one hand, this just seems to argue even louder for selling everything right now... but on the other hand, we have a number of major events that could happen in the next year or two that would drive the price much higher, and I can see our revenue pipeline much better than the rest of the investing market can. It looks dreamily fantastic. We are not a speculative company with theoretical dreams of future growth finally yielding a profit, we are just crushing our competitors in the space very slowly.

So it is a conundrum. My guess is I will just follow your advice, though, and sell most of what I can, and then allow the rest of the option stream to gamble on the future for me from a more moderated position relative to the portfolio.

Still, if anyone reading this has any other suggestions, keep 'em coming. I certainly appreciate it.

 

[MichaelB]

A few more thoughts from someone who didn't suggest you sell. There's not much a tax adviser will do beside tell you to hold the ISOs for the long term tax benefit. You can do the math so it probably won't be money well spent. A good financial adviser can help do two things - develop a plan to convert the options over time and show you how to get some downside protection, if you're interested. Options have lots of upside potential, so holding can be rewarding.

Some companies view options as a sort of loyalty test, and feel people selling are showing a lack of long term commitment. This may not be your case, but you might want to discreetly check, if you can.

 

[Animorph]

An advisor might show you how to hedge your shares without selling them directly. You could short your company or companies like yours or your market segment. Or use put/call type options to limit the downside a bit. Not something I ever considered, but I think my boss did some of that using an advisor. I think the advisor made a lot of money off him at least.

 

[clifp]

I faced a similar problem while at Intel. My general approach was to exercise any ISO as soon and then hold them until they qualified for LTC rates, the same thing was true for employee stock purchase plans. Although I didn't always follow my own advice, I think for diversification it is important to sell as much stock as practical if there is no tax advantage to keeping it. My colleagues who were greedy saw the stock price drop from the 70s to the teens after the dot com bubble and even today is barely 1/3 the price it was back at the top. On the other hand those folks who exercise and sold everything ended up with huge tax bills.

The delta between you current marginal tax rates (looks like 33%) and the LTCG rate of 15% is pretty significant. Even if the Bush tax cut expire next year the rate is still large 20% vs 36% plus what ever penalty you fall into because you make more than the magic $250K figure.

While the difference between AMT rates 26% or 28% is much smaller it is still significant on 1.5 million worth of stock. Plus you are likely end up in the situation that I did after retire. I actually got tax credit on the difference between AMT taxes I paid on the exercise of the ISO and the actual 15% cap gains I paid when I sold them. As result I've paid very little FIT after retiring. Although it has take a long time to get the credits used up finally using the last one this year.

Understanding the interaction between the regular tax code and the AMT with respect to stock options is mind numbingly complicated (easily as complicated as understanding execution streams on hyper threaded multi-core microprocessor). My accountant at the time was only right 80% of the time (which was better than my 50%). Given the money involved I can't emphasis the need to find a CPA who is familiar with stock option as well as potential strategy such as utilizing stock options to hedge your potions.

An excellent resource on taxes in general and certainly for the tax treatment of stock option is Fairmark.com. I have not read their book "Consider your options" but can't imagine it not being money well spent. The message board may also be a good source of information for finding a tax guy in your area who can help you.

 

[eridanus]

It may be too late but IRS 83-b could help.

 

[Symbiotic]

Some companies view options as a sort of loyalty test, and feel people selling are showing a lack of long term commitment. This may not be your case, but you might want to discreetly check, if you can.

Yeah, fortunately our team is very rational and understands diversification. It won't be the slightest problem there, but that sounds like good advice for the general case when someone is in a situation like this. Thanks.

 

[Symbiotic]

An advisor might show you how to hedge your shares without selling them directly. You could short your company or companies like yours or your market segment. Or use put/call type options to limit the downside a bit. Not something I ever considered, but I think my boss did some of that using an advisor. I think the advisor made a lot of money off him at least.

Thanks. I am pretty familiar with the various mechanisms to manage risk. Unfortunately, my company specifically forbids me from hedging my options. Interestingly, the way they specify those constraints is kind of archaic and technically leaves all kinds of holes and ways I could do it, but the intention is pretty clear. I prefer to play by the spirit rather than the letter of the "law" in this case!

I have thought about trying to hedge more generically, but it is hard to construct a set of specific investments that decorrelate with my company's performance. I have pretty much concluded that there's no magic here and that I should just treat my non-company-equity portfolio like it was a regular one -- in other words, not skew it because of my heavy concentration in one stock in my option grant pool.

 

[Symbiotic]

The delta between you current marginal tax rates (looks like 33%) and the LTCG rate of 15% is pretty significant. Even if the Bush tax cut expire next year the rate is still large 20% vs 36% plus what ever penalty you fall into because you make more than the magic $250K figure.

Yeah, I probably didn't explain that very well, but my calculations show that going for LTCG holding on my ISOs results in an effective FIT rate of about 25 or 26% under AMT, with the AMT credits carrying forward, with the FIT savings I'll get if I retire after a few more years and have very small incomes going forward. (I do show quite a few years of near-zero tax as I burn off the remaining AMT credit, like you describe.)

So by taking on the extra risk by holding for a year every time, plus the hassle of managing and reporting AMT, I probably move from 31 or 32% effective tax to 25 or 26% effective. And that's leaving aside state AMT considerations, which I also get to pay. (Yay.) So it's a pretty small improvement... not insignificant, but not nearly as compelling as the straight-up difference between STCG and LTCG, either.

Understanding the interaction between the regular tax code and the AMT with respect to stock options is mind numbingly complicated (easily as complicated as understanding execution streams on hyper threaded multi-core microprocessor). My accountant at the time was only right 80% of the time (which was better than my 50%). Given the money involved I can't emphasis the need to find a CPA who is familiar with stock option as well as potential strategy such as utilizing stock options to hedge your potions.

What finally cinched it for me was purchasing BNA. It really seems to do a good job of multi-year projections. After I worked my numbers up in there, I went to two local tax management/advisors. Both did not get even the medium-hard stuff right, much less multi-year projections with multiple ISO exercises sequenced over a period of 4 or 5 years. I then went to the guy who wrote that book you recommend, and I ended up talking to his wife a bit. She happens to be a tax person who also uses the same software, and she helped me validate that I was at least punching the numbers in correctly.

 

[Symbiotic]

It may be too late but IRS 83-b could help.

Thanks. As it happens, an 83b election in my first year would have been a smart choice in retrospect. (But, many of these decisions are easier in retrospect, are they not?) My subsequent options were at higher strike valuations, and I did not have a lot of cash sitting around, and that was all many years ago and our chances of success were markedly lower back then.

But, boy it would be nice to have LTG and minimal AMT on that first grant block, today. Ah well. Next startup, maybe.

 

[clifp]

At this point I think it is safe to say that you know more than the folks on the board and you aren't missing anything obvious. In general, I find the collective board's wisdom very useful for preventing people from doing stupid things, but not particular great and optimizing things that require specialized financial knowledge like stock options.

A million buck+ in stock options is nice problem to have!

 

[Symbiotic]

Well, I don't know about knowing more than the folks on the board, but I agree that it sounds like I haven't missed anything egregious.

I've learned a ton about finance and investing from reading this forum over many years, so I think major credit is due to you members anyway. Thanks for reading.

 

[Texas Proud]

One other thing that you do not mention, but I would suspect will happen since you indicate you are in a top management position....

What about NEW options I would bet that you are getting new ones (including the whole alphabet soup) of options each year as that is usually how companies handle bonus etc...

If so, I would be getting rid of as much as I could to keep my total investment in the company below 15% of overall portofolio... I know that some say 10%, but that is hard if you get a lot of compensation from options and stock grants...