Today, Amy Walls and Jag into the world of Non-Qualified Stock Options (NQSOs), a versatile form of equity compensation often offered to tech professionals. In our fifth episode of a six-part series, we explore how NQSOs, despite their simplicity in terms of taxation, require careful planning to effectively manage within one's financial portfolio.
NQSOs allow employees to purchase company stock at a predetermined price but come with no preferential tax treatment, meaning they are taxed as ordinary income upon exercise. This straightforward taxation can seem appealing, but it necessitates a keen understanding of one's tax situation, especially in pivotal life moments such as receiving a spouse's bonus or facing unemployment.
A key strategy in managing NQSOs is knowing when to exercise them to minimize the tax burden, particularly during years with lower income. However, it's crucial to only exercise options when the stock's market price exceeds the exercise price, ensuring a financial benefit.
Further discussing diversification, Amy emphasizes that once the stock is acquired through NQSOs, it should be treated like any other asset in the portfolio. The strategy here involves not just holding onto the shares hoping for appreciation but planning their sale to align with broader financial goals such as funding children's education, planning for retirement, or aiding family members financially.
Amy also shared a success story of "Emily," who leveraged her well-timed exercise of NQSOs to significantly advance her retirement plans and support her children's education, demonstrating the potent role these options can play in achieving financial independence and meeting family goals.
Conclusively, while NQSOs offer no direct tax advantages, their real value lies in strategic exercise and diversification, underscoring the importance of planning and professional guidance to avoid pitfalls and maximize potential benefits. Remember, it's not just about having the shares; it's about integrating them thoughtfully into your financial landscape to meet personal and familial aspirations.
Jag:
Welcome back to ThimbleberryU. I'm Jon Jag Gay. Amy Walls from Thimbleberry Financial joins me as always. Hello Amy, good to be with you.
Amy:
Jag, great to talk to you.
Jag:
So, this is the fifth in our six-part series geared toward tech professionals and with apologies to our friends at Sesame Street: This show was brought to you by the letters NQSO. Non-qualified stock options and how they fit into a tech professional's financial journey.
Amy, what can our audience expect from this episode and how can these NQSOs simplify equity compensation for the busy tech professionals that are listening?
Amy:
Well, first of all, I have to get Count Dracula out of my head with the alphabet right now. But non-qualified stock options, NQSOs, they are a versatile form of equity compensation pay that is frequently offered in the tech world or even outside of the tech world in publicly traded companies.
They allow an employee to purchase company stock at a specified price. Now, one thing to know is these are less common than they were when I became an advisor 20 years ago. And RSUs that we've talked about, restricted stock units are more in favor. So, we see less of these today than we used to.
Jag:
Gotcha. And if you want to know more about RSUs, we've got an episode on that you can go back to.
Amy:
Absolutely. So, we've also talked about incentive stock options, and I know we've really got this Sesame Street alphabet going on today. Those ISOs have some preferential tax treatment.
Now here's the good easy thing about non-qualified stock options. Not a great thing, but the easy thing, is that there is no preferential tax treatment, okay? They are taxed as ordinary income upon exercise. So, when you exercise, you are going to have a tax bill for the difference between the exercise price and the stock price that's due in a calendar year.
I will still say though, just like when we talk about other things, understanding that tax implication is crucial. It's simpler, but it's still crucial because it's immediate.
Jag:
Yeah. You don't want to get caught making a mistake there and not being able to undo something, for sure.
Amy:
Correct.
Jag:
Amy, how can our tech professionals effectively manage these NQSOs and stuff we talked about before but use diversification strategies to their advantage in this case.
Amy:
So, Jag, it's a great question. I said these are simple. The taxation is simple and what we need to think about is first when to exercise. Because when we exercise, we're going to have a tax bill for that current year.
So, let's say someone has shares vesting over four years. Great, they all vest. They don't exercise in that time, but the shares are also going to expire at the end of 10 years from when they were granted. So, we have this window of time to make choices. This requires thoughtfulness, really.
And some forethought that may not be perfect, but it's good to have an idea of what you think may happen in those 10 years in order to make decisions and you can always adjust accordingly.
Let's say it's a couple and one of them has these non-qualified stock options and they're vesting and they're considering exercising at that time, they're going to incur a tax bill and their spouse gets a really big bonus in pay raise.
Jag:
I see where you're going here.
Amy:
Alright, this may not be the best time to exercise because that tax bracket may be so high.
Jag:
So, it's not just considering these NQSOs, so it's considering your overall tax burden, tax picture for that year. Conversely, if your spouse was laid off and out of work for six months, then you look at it from the opposite perspective.
Amy:
Absolutely. And in all of that, we want the stock price ideally to be higher than the exercise price. That doesn't make sense to buy the shares through the non-qualified stock option when the stock is lower, we'd rather just go onto the market and buy the shares.
Let me give an example here. Let's say that your stock options allow you to buy shares of XYZ company at $25 a share and the stock price is $40. You're getting a $15 discount per share on the purchase of the stock price.
You're not going to want to exercise though if the stock price is $15 a share because it's $10 less. If you were to exercise, you'd be spending $10 more per share to buy the stock. You might as well just go out onto the market and buy it at $15 a share.
Jag:
So, the exercise price is locked in is that's what you're going to buy it for. You want to buy it when it's a discount, not when it's more expensive than it would've been otherwise.
Amy:
Correct. So, in this strategy, what you also want to think about is how's the company doing? How's it expected to do? Now this is hard because as employees we all get that bias towards the companies we work for, for good or for bad.
So, having some idea of where you think this might head, but also trying to take the emotion out of it. And obviously as a financial advisor, I'm going to say that is one of the key roles that I play with clients in this type of situation is there's a process, a method, this is the plan, we're agreeing on it, let's execute to get the emotions and the bias out of there.
Jag:
Got it.
Amy:
Talking about them first upfront. Those are some of the ways that these can be managed.
Now in terms of your question about diversification, Jag, these are a perfect diversification tool because once you have the shares, there's no benefit necessarily to holding.
Yes, there's long-term capital gains and short-term capital gains and all of that. And so, you hold more than a year, great.
But if you've just exercised and you've just paid ordinary income, well it's not going to matter going forward unless the stock price changes a lot, maybe nine months down the road and then you might want to hold to a year to get long-term capital gains.
Jag:
If I'm understanding you correctly here, Amy, the real key here is the set price for when you are getting the stock. Once you have the stock essentially because there's no specific tax implications here, it's just like anything else in your portfolio.
Amy:
Exactly. And so, it's a great diversifier, but you need to have strategy again.
Jag:
Yes. Just like everything else in your portfolio.
Amy:
Exactly. If I've got a hundred thousand shares of stock LMNOP, since we're on the alphabet today, and obviously there is no stock LMNOP. But if I've got a hundred thousand shares of that, well am I still diversified? That depends on my whole portfolio and how big of a portion LMNOP is in relation to the whole thing.
Jag:
You don't want it to be too big of a slice of the pie. The only reason you could have that many shares is if it was a really big pie.
Amy:
Yes. So, typically concentration is 5%. Anything that's over 5% of your portfolio in a single holding is unsafe, 10% is definitely concentrated. But we also have to be factoring in the fact you work for the company or at least LMNOP, if I work for the company, I have to factor that in. That's part of diversification.
So, it might be that there's a plan for exercising the stock and maybe there is kind of a dollar cost averaging strategy, meaning every month, every quarter, to get out of this stock and put it into something more diversified that fits your overall portfolio.
It's about intentionality because the thing that happens often without having that strategy is the stock ultimately gets sold when, “Hey, this remodel seems like a great idea.” And it's not factored into what can these assets do for you from a retirement saving standpoint, from your financial goals standpoint. And that's when money slips through the cracks and just isn't there for what's most important to you.
Jag:
Makes sense. Now, it comes down to the planning like we talk about every couple weeks here, Amy. Let's pivot a little bit and talk about some success stories. Do you have any stories without names of course, of tech professionals who made wise use of those NQSOs in their financial journey?
Amy:
Someone, who I'm going to call Emily, comes to mind. Emily exercised her options during good market conditions and ended up diversifying her portfolio. So, she had quite a bit of company stock, didn't have a strategy. We looked at that and said, “Okay, here's how we do this.”
She used that money and put that proceeds first to her kids' education. And so, her kids are about — well off to and about to be off to school.
And she used the rest of that money to make significant headway towards retirement goals and has the option to retire much earlier than when she intends to retire or what she thought was going to be possible.
And it was all about laying out that plan and saying, “Okay, you've got these, you have the ability to exercise, here's a way to do that and let this money go towards the things that are important to you.”
Jag:
Amy, you're starting to answer my next question, but I'll ask it anyway. How can these NQSOs contribute to both financial independence and family goals for tech professionals more generally, I guess?
Amy:
Yeah. And Jag, I think, sorry that I beat you to the punch on that one. It ties back to your question about diversification. If you use these dollars and put them into your other financial priorities, that doesn't mean you also can't play with some of this money perhaps. It's all about your financial situation and what you want to achieve.
If you're not wanting to retire until 70, it's a different scenario than if you want to retire at 45 and the strategies are going to be different. So, it's knowing those goals, then using these assets to plug in, supplement other things you're doing.
These probably can't be the only thing you're doing towards financial goals, but they're a supplement. They're a key piece of the puzzle to make the things happen that you want to have happen.
So, I guess more explicitly, it's accelerating a path to financial independence or a path to retirement perhaps. Or making sure that you're not worried about kids' education or purchasing that vacation home that you've dreamed about for when you expect to have grandkids. Another way that I've seen people use these dollars is to support aging parents.
Jag:
Wow. Okay.
Amy:
They look at this and say, “Well, I'm in a good financial position, my parents aren't. That's one of the goals I'm taking on is I want to be able to help them without hurting myself, without hurting my kids, how can I do this?”
Well, this was free money, maybe the stock price was underwater for a while. And it comes up. Well, we weren't counting on it. Let's use this money to do that.
Jag:
I like it. Well, I do have to ask you, in the interest of being thorough here, are there instances where you've seen people get stuck with these NQSOs?
Amy:
Oh yes, I have. That's a great question, Jag. The examples that come to mind for me right now are when someone leaves an employer. Most often when they leave unexpectedly, but sometimes when they leave expectedly and didn't think through the whole process.
Most of these, when you leave an employer, and this is written into the grant letter/grant notice, you have 90 days to exercise shares, or you will lose them. So, someone doesn't pay attention to that timeframe, and they lose the shares that did have value.
Additionally, once you leave an employer, you're going to need cash to exercise. So, perhaps before you leave, if you know you're leaving, you'd want to do a cashless exercise if you don't have enough cash on the sidelines.
That's where the employer basically says, “Hey, you've got a hundred thousand shares of LMNOP,” which is the company you work for. And they say, “We will pay for the price to buy these $15 a share, for example. But then once you have all the stock, we're immediately selling that portion to get our money back.”
So, doing a cashless exercise provides liquidity. It doesn't make you take all your cash to buy the stock and if you're not working, you probably need your cash.
So, planning for that is important. And then because these are tax ordinary income, not working with your CPA and your financial advisor to project and estimate what that tax bill will be, especially when you're going to hold the shares, you need to have another way to pay that tax bill.
Jag:
Got it. All things to consider, and as we talk about plan, plan, plan, work with a professional like Amy so you don't end up like Oscar the Grouch and living in a trash can. Sorry, had to bring it full circle, Amy. (laughter)
She's cracking up and I'm hoping she can recover to tell you how to find Thimbleberry Financial on the phone and on the web.
Amy:
Yes, I have all sorts of Sesame Street things going through my head right now, but if you are wanting to talk to us, please give us a call at (503) 610-6510 or find us online at thimbleberryfinancial.com.
[Music Playing]
Jag:
Alright. Thank you for this production of Thimbleberry Financial, we’ll talk in a couple weeks.
Amy:
Sounds great, Jag.
Jag:
Securities offered through registered representatives of Cambridge Investment Research, Inc, a broker-dealer member of FINRA/SIPC. Advisory services through Cambridge Investment Research Advisors, Inc, a registered investment advisor. Cambridge and Thimbleberry Financial are not affiliated.
Discussions in this show should not be construed as specific recommendations or investment advice. Always consult with your investment professional before making important investment decisions.
Securities offered through registered representatives of Cambridge Investment Research Inc, a broker-dealer member of FINRA/SIPC. Advisory services through Cambridge Investment Research Advisors, Inc, a registered investment advisor. Cambridge and Thimbleberry Financial are not affiliated.