Pam Krueger
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One of the big reasons you’re giving 110% of your talent and effort to your private company is because you’re hoping to eventually cash in on all those vested incentive stock options (ISOs) that have been sitting in some account, waiting for the day your company goes public.
There’s nothing wrong with that. Who doesn’t dream of reaping an options windfall and using it to retire early, buy a house, pay off their college loans, travel around the world or become a full-time philanthropist?
Unfortunately, when it comes to figuring out how to cash in their stock awards, most employees are on their own.
Their employers can’t always provide the answers they need — especially when the questions relate to personal finances. Most companies admit they need to be better at explaining how ISOs work in general, but they can’t legally work one-on-one with employees to help them exercise and sell shares the right way.
That’s why, when the time is right, many employees actively look for help from a qualified fiduciary financial adviser who can walk these could-be “options millionaires” through various cash-in scenarios.
Here’s a real-life example (using a pseudonym).
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. 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 expected to increase this year, you could be closer to cashing in your vested ISOs than you think.
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 adviser.
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.
Disclaimer: WorthPointe, LLC is an investment adviser registered with the U.S. Securities and Exchange Commission (SEC). Registration of an investment adviser does not imply any specific level of skill or training and does not constitute an endorsement of the firm by the SEC. A copy of WorthPointe’s current disclosure brochure, which describes, among other things, WorthPointe’s business practices, services and fees, is available through the SEC’s website at www.adviserinfo.sec.gov. The client in this article was referred to WorthPointe Financial Planners through Wealthramp.
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