Have you ever been close to the end of a 60-hour work week and thought to yourself, “After all the work I put in for this company, I should own part of it”? Well, you’re probably right, and chances are, you already do—with non-qualified stock options. Non-qualified stock options are a common type of executive compensation that essentially gives employees a vested interest in the success of a company.
While owning non-qualified stock options is common among top-level executives, many haven’t given much thought to how to invest them. If this sounds familiar, rest easy, you are not alone. Stock options are rarely talked about when it comes to investing, even though they typically make up a large portion of a top-level executives’ overall net worth. The good news is that, by working with an experienced executive financial advisor, you can learn more about strategies for investing non-qualified stock options and make informed decisions that benefit your financial portfolio.
Understanding Non-Qualified Stock Options
To understand how to invest non-qualified stock options, I find it helps to first define them. A non-qualified stock option is an alternative form of income that employers offer to employees. This is typically done as a way to reward employees and incentivize them to push the company forward, as well as to hold their employment long term with the company.
Non-qualified stock options are given at a set price at which the employee can purchase company stock once they are fully vested, which is typically anywhere from one to six years. The purchase of company stock at the preset price is known as exercising the options.
The idea behind the preset price is that the stock will be worth more in the future. So when the employee exercises the options at the lower, preset price and sells the stock at a higher price, it will result in a financial gain. The financial gain is taxed as ordinary income in the year in which the stock is sold.
It is important to note that non-qualified stock options are different from incentive stock options, sometimes referred to as ISOs. There are some key differences between non-qualified stock options and ISOs, but a big one is that ISOs are taxed at either the long-term or short-term capital gains rate, depending on when and how the stock is exercised and sold. Non-qualified stock options are more favorable on a corporate tax level and also more easily managed on a corporate level, which is why they are often offered to top-level executives over ISOs.
4 Ways to Invest Non-Qualified Stock Options
There are four common ways to invest non-qualified stock options: sell off, invest in other assets, hold long term, or exercise your options and hold the stock. Each strategy has its pros and cons, so let’s take a look at each one in more detail.
Sell off. One way to invest your non-qualified stock options is to exercise your options and sell the stock as soon as possible. This could be a strategy used when you have some certainty that your income tax bracket will be increasing in the near future, and you wish to pay a lower tax percentage from the sale of the stock. This is not typically a strategy that makes sense for executives because you would be paying income tax on all of the stock in one given year. However, if you have other investments, such as real estate, on which you have taken a large loss in a given year, you could consider selling the stock in the same year to take advantage of your lower taxable income.
Invest in other assets. If you own a considerable amount of company stock that amounts to a large percentage of your overall net worth, you might consider exercising your non-qualified stock options and selling to diversify your portfolio. Although you would pay ordinary income tax on the company stock that you sold, it would help you address the concern of putting all of your eggs in one basket, as the saying goes. This is a strategy that an executive should consider on an annual basis. If your company has experienced tremendous growth, your stock options could be shooting up in value and simultaneously throwing off the balance of your investment portfolio.
Hold long term. Another strategy for investing your non-qualified stock options is to simply hold onto them. Some executives fall into this strategy without giving it any thought because they are simply too busy to consider other investment plans for their stock options. However, this strategy should be evaluated annually to account for any changes that might affect it—like the value of the stock increases dramatically or something alters your financial situation. One benefit of this strategy is the ability to offset the taxation that will occur when you do decide to exercise and sell your options. If you are able to wait until retirement, you could be in a much lower tax bracket at the time and effectively save yourself a considerable amount of taxation.
Exercise and hold. A similar strategy to holding long term is to exercise your non-qualified stock options and then simply hold on to the stock. If you wanted to pay the tax sooner rather than later for the exercising of your options, possibly because your income was lower than normal in a given year, this strategy would make sense. Doing this, you would own the stock outright, so the only way it would make sense to hold onto the company stock over buying an alternative investment is if you had faith that the company stock would continue to rise and outperform other investment options. You would want to evaluate this strategy at least quarterly to keep a close eye on the stock price changes in the market.
While this is not an entirely exhaustive list of all the ways in which you can invest non-qualified stock options, these are some of the most common methods for executives to consider. The most important thing to remember is that your unique financial situation will drive your strategy. Some of my clients are just starting to pay for their children’s college tuitions, while others are a year away from retiring on the beach. The point is, everyone is in a different season of life. As you go through the seasons, working with a trusted wealth manager to continually evaluate your investment strategy—including how to invest your non-qualified stock options—will help ensure your strategy makes the most sense for you.
K. Wade Carpenter, CFP®, AIF®, ChFC®, CLU®, is an innovative wealth manager serving corporate executives and entrepreneurs from coast to coast. Throughout his more than 25-year career, Wade’s focus on C-level clients has made him a top strategist for integrated asset allocation and equity compensation management. For more information on how Wade and the Carpenter Team can advise you on how to invest non-qualified stock options and executive compensation, reach out today for a complimentary consultation.
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