Do you work for a start-up company? If so, then you probably understand how challenging and demanding the work schedule and responsibilities can be. Most start-up employees give their heart and soul for their employers in hopes of one day reaping the rewards by cashing in on their vested incentive stock options (ISOs) that have just been lying dormant in a trading account waiting for the company to go public. It’s perfectly normal to dream about the day you’ll be rich. Who wouldn’t want to live that life? Everyone should cash in on all their blood sweat and tears if given the option to retire early, buy a house, start a family and start saving for the future. But it’s important to make sure you’re getting the absolute most out of all the hard work you put in over the years.

Unfortunately, when it comes to understanding how to properly cash out their options and save thousands on taxes, most employees are left to figure it out on their own. Some will try and navigate the often complicated and confusing landscape that is employee stock options, however most often seek out assistance from a qualified fiduciary financial advisor. A good financial advisor will take the stress off your plate and walk you through your various cash-in options, so you can worry more about how you’re going to be spending your money. 

Benefits of Working With an Advisor on Stock Options Planning:

1. Help you understand the potential tax (including alternative minimum tax, AMT) implications of exercising and selling stock options
2. Develop a comprehensive financial plan that enables you to spend some of your options windfall today while investing the rest for retirement, college and other financial goals
3. Draft a schedule for selling exercised ISOs over several years to help you avoid short-term capital gains and mitigate the tax impact of long-term capital gains
4. Explore options for selling your vested private shares before your company goes public

Now cashing in your stock options isn’t always sunshines and rainbows, in fact most investors are often left losing sleep over the amount of money they are required to pay Uncle Sam. However, there are ways to minimize your tax bill by creating a stock options tax treatment plan   with a little help from your advisor. A smart financial advisor will work in partnership with your tax manager to help you navigate when it makes sense to take a disqualifying disposition and review the stock option exercise tax implications with you. Your financial advisor can be a great resource and tool for you to use in helping you understand what your options are, but they can’t guarantee that you won’t make any mistakes. Mistakes happen all the time, but don’t wait until it’s too late to help yourself out.

Most Common Mistakes Investors Make With Stock Options Planning:

1. Not doing employee stock option planning
2. Not starting the planning process early enough
3. Waiting to create the basic financial plan until it’s too late
4. Thinking stock option planning can be done in a vacuum

Client Success Story

Kurt is a 50-year-old VP of product management at a healthcare startup that just went public. Over his three years with the company, Kurt had amassed 350,000 ISOs worth approximately $6 million. Now, unlike many options millionaires, he didn’t intend to cash in everything and retire early. He planned to stay with the firm but wanted to liquidate enough ISOs to pay for a vacation home and add greater diversification to his investment portfolio. This presented significant tax risks that Kurt wasn’t aware of. If Kurt exercised his ISOs and sold the shares before a year had passed, his profits would be characterized as short-term capital gains, which are taxed as ordinary income.

To illustrate the potential tax implications of this action, we created a hypothetical scenario that showed if Kurt exercised all of his ISOs and sold the shares immediately, he would incur approximately $6 million in ordinary income, which would push him into the top tax bracket and put him on the hook for almost $3 million in combined federal and state taxes. On the other hand, we created another hypothetical scenario showing Kurt that if he designed a strategy for staggering his options exercise over a few years and waited to sell his shares at least one year after exercise, he might incur substantially less in taxes and potentially save up to $1.5 million compared to the “exercise and sell” strategy. 

The reason for this is because ISOs have a unique feature that allows you to pay long-term capital gains rates when you sell the stock, which is often a lower rate than ordinary income rates. Still not cheap, but a lot better than $3 Million. These two scenarios were purely hypothetical, and the actual results could be different when Kurt actually took action, depending on the market price of the shares when he sold them. If the price fell, his windfall could shrink, but, on the plus side, this could also reduce his capital gains tax hit. In the end, Kurt agreed that it was better to adopt this less-taxing “exercise and hold” strategy and only liquidate a portion of his ISOs each year, rather than all at once.

In year one, with the right financial plan, Kurt was able to sell enough to pay for his vacation home. Next up, Kurt wants to invest the proceeds from future sales to save more for retirement and other financial goals. Maybe a decade ago Kurt’s situation would have seemed unique. But with global IPOs hitting record levels in 2020 and a trail of pent-up IPOs now that markets have cooled, this might be the time to take a closer look at your vested ISO strategy. And if you’re not, there are other options. For example, if you’re thinking about leaving your firm before it goes public, you may be able to exercise your vested ISOs using private shares. The value of your shares will be determined by its IRS Section 409A valuation, which is calculated at least once a year. 

The same tax implications and timing choices apply even with private shares, so if you’re facing this dilemma and aren’t sure how to move forward, your first step may be to meet with a qualified fiduciary financial advisor. Regardless of whether you work with a professional or cash in your ISOs on your own, it’s important to assess how your actions could impact your entire financial picture, especially your potential tax liability. When the stakes are this high, it’s never advisable to make decisions in a vacuum.

"Thank you John for this extremely informative and timely guest post, we greatly appreciate the information! John’s advice couldn’t come at a better time. If you don’t currently have an advisor or if you’re interested in another perspective on your current investment strategy, be sure to check out Wealthramp’s quick survey that will match you with three fee-only, fiduciary financial advisors in your area. The first advisor meeting is always free and you’re under no obligation to hire any professional. Learn more about the Wealthramp process and be sure to check out Wealthramp’s resources on portfolio diversification, among other important tools to help you navigate divorce planning, charitable giving, and much more!"

- Pam Krueger