Unpacking Incentive Stock Options

Contributed by: Matt Trujillo, CFP®

What is an ISO?!

Some of you reading this might have been granted Incentive Stock Options (ISOs) in the past or perhaps this is something that your employer recently started to grant you. In either case it never hurts to get a refresher on what they are and some of the nuanced planning opportunities that go with them. ISOs are a form of stock option that employers can grant to employees often to reward employees' performance, encourage longevity with the company, and give employees a stake in the company's success. A stock option is a right to buy a specified number of the company's shares at a specified price for a certain period of time. ISOs are also known as qualified or statutory stock options because they must conform to specific requirements under the tax laws to qualify for preferential tax treatment.

The tax law requirements for ISOs include*:

• The strike price—the price you will pay to purchase the shares—must be at least equal to the stock's fair market value on the date the option is issued.

• To receive options, you must be an employee of the issuing company.

• The exercise date cannot be more than 10 years after the grant.

*Special rules may also apply if you own more than 10 percent of your employer's stock (by vote). Nonqualified stock options, another type of employee stock option, are separate from ISOs therefore receive different tax treatment.

Once you have been granted a stock option, you can buy the stock at the strike price even if the value of the stock has increased. If you choose to exercise a stock option, you must buy the stock within the specific time frame that was set when the option was purchased or granted to you. You are not required to exercise a stock option.

Your options may be subject to a vesting schedule developed by the company. Unvested options cannot be exercised until some date in the future, which often is tied to your continued employment. The stock that you receive upon exercise of an option may also be subject to a vesting schedule.

Assuming that a stock option satisfies the tax law requirements for an ISO, preferential tax treatment will be available for the sale of the stock acquired upon the exercise of the ISO, but only if the stock is held for a minimum holding period. The holding period determines if a sale of the stock you received through the exercise of an ISO is subject to taxation as ordinary income or as capital gain or loss.

To receive long-term capital gain treatment, you must hold the shares you acquired upon exercise of the option for at least:

• Two years from the date you were granted the option, and

• At least one year after the date that you exercised the option

So whether this is something new to you or something you’ve been handling for a long time, feel free to contact us with questions regarding the nuances around Incentive Stock Options.

Matthew Trujillo, CFP®, is a Certified Financial Planner™ at Center for Financial Planning, Inc.® Matt currently assists Center planners and clients, and is a contributor to Money Centered.

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This information does not purport to be a complete description of Incentive Stock Options, this information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Investing in stocks always involves risk, including the possibility of losing one's entire investment. Specific tax matters should be discussed with a tax professional.

Investor Basics: Stocks 101

Contributed by: Nicholas Boguth

Earlier in the Investor Basics series, we went over the basics of bonds. Now we’re going to switch gears to the equity side of the investment universe, and gain a better understanding of the basics of stocks.

What is a stock?

A stock is a claim on a company’s assets, or in other words, a share in ownership. If you own a stock, then you own a piece of the company.

The major difference between stocks and bonds is that bonds have a contractual agreement to pay interest until the bond retires, while owners of stocks have a claim to assets so they hope to make money on capital or price appreciation and/or dividend income. Another major difference between stocks and bonds is that owners of stocks do not get paid in the event of a company’s bankruptcy until after all the bond holders are paid. For these reasons, stocks are typically considered “more volatile” investments.

What are the different types of stock?

There are two main types of stocks – common and preferred.

When hearing people talk about stocks in everyday conversation, it is usually safe to assume that they are talking about common stock. Common stocks are much more prevalent in the market. The major difference in characteristics of common stocks and preferred stocks are – 1. Common stocks do not have a fixed dividend, while preferred stocks do, and 2. Common stocks allow the investor to vote on corporate matters such as who makes up the board of directors, while preferred stocks do not.

Voting rights depend on the number of shares that you own. If you own 1000 shares, you have 1000 votes to cast. Most companies allow votes to be cast by proxy, so the individual investor does not have to be present at things like annual meetings in order to cast a vote. Proxy votes can typically be sent in by mail, or nowadays it is common that you will be alerted via email that you are able to vote on a company’s policy and you may cast it quickly online.

Preferred stocks may not allow the investor to vote on policies, but they do have a fixed dividend that is typically higher than the dividend of a common stock, and in the event of liquidation will be paid before common shareholders (but after bond holders). You may note that a fixed dividend sounds a lot like the fixed interest payment of a bond. This is true, but there is no contractual obligation to pay the dividend on stocks. These similarities typically make preferred shares act like something in between a stock and a bond – something that does not participate in the price movement of a company as much as a common stock, but receives a fixed dividend similar to the interest payment of a bond.

Nicholas Boguth is an Investment Research Associate at Center for Financial Planning, Inc. and an Investment Representative with Raymond James Financial Services.

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This information does not purport to be a complete description of the securities referred to in this material, it is not intended as a solicitation or an offer to buy or sell any security referred to herein. Investments mentioned may not be suitable for all investors. Investing in common stocks always involves risk, including the possibility of losing one's entire investment. Dividends are subject to change and are not guaranteed, dividends must be authorized by a company's board of directors.

What You Need to Know about Stock Options

Contributed by: Nick Defenthaler, CFP®

As a professional, there are various ways you can be compensated for your work.  Although not as prevalent as they once were, stock options still exist in many different companies and can often be negotiated into your overall compensation package.  Stock options are intended to give you motivation and incentive to perform at a high level to help increase the company’s stock price which will, in turn, have a positive impact on the value of your own stock options.  There are various forms of stock options and they can certainly be confusing and even intimidating.  If you’ve ever been offered options, your initial thought might have been, “I know these things can be great, but I really don’t have a clue what they are or know what to do with them!” For starters, there are two common forms of stock options NSOs & RSUs.

NSO: Non-qualified Stock Options

Non-qualified stock options, or NSOs, have been around and very popular for decades.  The mechanics, however, can be a bit tricky which is partly why you don’t see them quite as much as you used to.  There are various components to NSOs, but to keep things simple, the company’s stock price must rise above a certain price before your options have value.  Taxes are typically due on the difference between the market value of the stock upon “exercising” the stock option and what the stock price was when the option was “granted” to you.  Upside potential for NSOs can be significant but there’s also a downside. The options could expire making the stock worthless if it does not rise above a certain price during the specified time frame.

RSU: Restricted Stock Units

Restricted Stock Units, or RSUs, have become increasingly popular over the past 5 – 10 years and are now being used in place of or in conjunction with NSOs because they are a little more black and white.  Many feel that RSUs are far easier to manage and are a more “conservative” form of employee stock option compared to NSOs because the RSU will always have value, unless the underlying company stock goes to $0.  As the employee, you do not have to decide when to “exercise” the option like you would with an NSO.  When the RSUs “vest”, the value of the stock at that time is available to you (either in the form of cash or actual shares) and is then taxable.  Because you do not truly have any control over the exercising of the RSU, it makes it easier and less stressful for you during the vesting period.  However, because the RSUs vest when they vest, it does take away the opportunity to do the kind of pro-active planning available with NSOs.

Stock Options and Tax Planning

As you can see, stock options have some moving parts and can be tough to understand.  There are many other factors that go into analyzing stock options for our clients and we typically also like to coordinate with other experts, like your CPA because tax planning also plays a large part in stock option planning. If stock options are a part of your compensation package, it is imperative to have a plan and make the most of them because they can be extremely lucrative, depending on company performance and pro-active planning.  Please reach out if you ever have questions about your stock options – we work with many clients who own them and would be happy to help you as well!

Nick Defenthaler, CFP® is a CERTIFIED FINANCIAL PLANNER™ at Center for Financial Planning, Inc. Nick is a member of The Center’s financial planning department and also works closely with Center clients. In addition, Nick is a frequent contributor to the firm’s blogs.

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US Stocks & the Federal Reserve - 2nd Quarter 2012

As the saying goes, “Don’t fight the Fed!” Many investment experts have noted the strong relationship between the market’s ups and downs and Federal Reserve policy. This chart, compiled by Doug Short at dshort.com beautifully illustrates the relationship between Fed intervention programs and the S&P 500. 

While Operation Twist is scheduled to end in June 2012, Federal Reserve board members have also started to use stated future targets for interest rates as a means to encourage market participants to invest in stocks. As recently as April 11th, Fed Vice Chair Janet Yellen indicated that the Fed’s “Zero Interest Rate Policy” could remain even past the initial 2014 target date. If markets stumble, some think that a third round of Quantitative Easing may also be possible.

There will come a time when markets need to stand on their own two feet. Based upon the words and deeds of the Fed, those days may be several years away.

Hat Tip: The Big Picture, Barry Ritholtz.

U.S. Stocks - 1st Quarter 2012

Last year the S&P 500 – a bell-weather for American stocks – was statistically unchanged from a price perspective.  When you add in dividends, the index was up 2%.  You may be feeling a lot more bumps and bruises from the year in stocks than a flat 12-month return would indicate.  Markets had wild swings and Ron Griess of the Chart Store (Hat Tip ritholtz.com) reports that 2011 was the seventeenth most volatile year for the S&P 500 since 1928.  Perhaps not surprisingly, 2008 and 2009 were even more volatile.  All of this has presented a behavioral challenge for investors with the temptation to time the market or get off the bumpy ride.

As with anything, it is very difficult to predict volatility.  It’s best to plan, though, for more ups and downs.  Volatility seems to come in patches with 15 of the 17 most volatile years for the S&P coming between 1929 and 1939 or between 2000 and 2011.  Managing your investment behavior through allocation planning, regular rebalancing, or the advice of an investment professional is critical to help avoid paralysis or bad timing.

Returns of large US companies surged ahead of their smaller peers. While large company S&P returned 2%, the Russell 2000, a common index for small companies, was down 4%.  The Dow Jones Industrial Average, even bigger than the S&P as measured by market capitalization, returned 8%.  Still, smaller stocks have outpaced large stocks cumulatively since March 2009 (when using the same indexes).

Many have watched for large companies to outperform due to compelling valuations and diversified revenue sources.  This trend may continue with strong profit margins, cash on the books, and still interesting valuations relative to larger stocks.

Dividend-paying companies, especially those outside of the financial sector, rewarded their investors handsomely in 2011.   Dividends fulfilled their promise last year helping both the total return of companies as well as raising interest from investors for their companies themselves.

We still like dividends for reasons Angie Palacios, CFP® I explained in a recent blog post.  Dividend yields are attractive relative to interest that bonds pay across the world.  Furthermore, as more boomers retire and seek a more steady income stream (no small feat in a low-yield world), a strategy that includes dividends may remain attractive relative to their cash-hoarding peers. *Dividends are not guaranteed and must be authorized by a company’s board of directors.