The Planner's Perspective: Overwhelmed by Options

Paul Morrone |

By Paul Morrone CFP®, CPA/PFS, MSA

The term ‘stock options’ is kind of a catch-all to describe a form of incentive compensation usually awarded to a select group of highly compensated employees. Options can come in many forms, which is why there is often a lot of confusion surrounding stock as a form of compensation and what it means to the person receiving it from an ownership and tax standpoint. There are numerous articles which cover these two items in detail, but what is often unaddressed is the financial planning impact of having stock options and what it means from risk, income and asset allocation perspective (the ‘big picture’ stuff).

Exposure to one company’s stock, either directly because of owned shares or indirectly through the right to acquire company shares through options in the future, can create a significant concentration risk in an individual’s portfolio that may not be reflected on traditional reporting (i.e. monthly/annual) statements. From a risk management standpoint, an individual should consider the current and future exposure to the company’s stock as options are granted and vest over time. This concentration risk can further increase if the individual has material exposure to company stock in other locations in their portfolio such as their 401(k) plan or taxable investment accounts, in addition to options granted through their plan.

Sometimes, having an outsized position in one company is unavoidable, especially for senior executives or someone that was acquired by, or founded, a company that issues stock. While the latter of these cases is less common, all option holders should be aware as to how sensitive their financial plan is to the changes in the price of a company’s stock. For those with the ability to manage their liquidity and reinvest free cash flow into other assets, we often recommend diversifying other holdings outside of company stock to include investments that are less correlated with a specific company or sector performance.

To assess the magnitude of concentration risk, the timing, amount and type of options must be analyzed to understand the tax and net worth implications of exercising (or not exercising) options during a certain period of time. This can be further complicated by the different types of options an individual may own, each of which is likely impacted by various external factors (time, share price, etc.). Proper planning can help to maximize the after-tax value of the options as most option types have significant tax implications that should be accounted for during an annual planning meeting with your accountant and advisor.

Once an individual has amassed a material position in a company stock, the characteristics of that stock will play an integral role in their financial plan from an income, tax and estate planning standpoint. For investors who need income, but own stock that doesn’t pay dividends, shares may need to be liquidated in the future to generate income. This will require careful management of capital gains and potential reinvestment of proceeds to income generating investments to help fund future cash flow need. Additionally, a clear understanding of basis and holding period for each lot of shares acquired is critical to making informed decisions on which shares to gift, keep or sell as part of the estate planning process.

We always recommend assessing your stock option plan with respect to your overall asset allocation and potential concentration risk as part of a comprehensive financial plan. Because of the interrelation of stock options with other material areas of your financial household, it is impossible to look at their current or future value in a vacuum without considering a myriad of other planning considerations.

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