WEIGHING OPTIONS.

CASHING IN STOCK OPTIONS REQUIRES A STRETCH THIS SEASON

ARE STOCK OPTIONS A BLESSING OR A CURSE THIS TAX SEASON?

Options have been a popular form of incentive compensation during the tech revolution of the past decade, for executives and even rank-and-file employees of both private and public companies. It's estimated that more than 90 percent of Fortune 1000 companies use stock options either as an incentive to retain employees or as a perk to lure new talent to a company facing a tight labor market.

The recent spate of volatility in the stock markets, however, coupled with complex tax laws associated with stock options, have created some difficult financial-planning conditions for those who hold or exercise such benefits.

Stock options come in two varieties: incentive stock options (ISOs) and non-qualified stock options (NSOs). Either type can be a blessing or a curse this tax season, depending upon when you exercised the options and sold the underlying shares.

THE ROLLERCOASTER

Employees with stock options usually are vested in them over a certain period, and can exercise the options by buying the stock at a stated price -- often much lower than the market value of the shares when vested. Over the past decade, as employees were vesting in their options, the stock market was roaring ahead, with the S&P 500 recording five consecutive years of gains over 20 percent.

For instance, here in Colorado, the initial public offering of stock in J.D. Edwards (JDEC) made many executives holding stock options wealthy. The company went public at $23 per share in 1997. The stock quickly moved up to $35 per share in a day and worked its way up to a high of $49.50 in one year.

DOWNHILL

From the late 1990s until now, the volatility of the markets turned up several notches, leaving many option-holding executives with manic-depressivelike symptoms.

J.D. Edwards peaked at $49.50, for example, and then dropped like a rock to $25 in about a month. The price then worked its way up to more than $35 a share before steadily declining to about $11. Over another year, it again moved up to near its historic high before crashing to its all-time low of $10.25.

Then it went through yet another cycle -- up to $30 and down again to $15.

The J.D. Edwards example is just one of many similar situations that thousands of executives across many different industries have had to endure in Colorado and around the nation.

Proactive planning can enable executives holding stock options to develop sound strategies for when and how to exercise the options. Here is a simple three-step optimization process:

EVALUATE THE TYPE OF OPTIONS YOU OWN. Make sure you understand what type or combination of options you own: non-qualified stock options (NSOs) and "qualified" or "incentive stock options" (also referred to as ISOs).

Non-qualified stock options are sometimes called non-statutory stock options. They allow you to participate in the growth and success of your employer by benefiting from an increase in your company's share price, but they have less-desirable tax consequences than ISOs.

Exercising an NSO is like receiving a cash bonus. The difference between the exercise price and the price of the stock when you exercise it is ordinary income in the year you exercise the NSO. Thus, it is normally tax advantageous to wait as long as possible (usually up to 10 years) before you exercise an NSO so that you maximize growth and tax deferral. But you also may want to exercise an NSO in order to diversify your investment portfolio.

Incentive stock options are the most tax-advantaged way to share in the growth of your company -- but out of ignorance, many executives do not take advantage of the preferential tax treatment available to ISOs.

The primary tax advantage of ISOs lies in holding onto the shares. If you hold optioned shares for at least two years following the date of an option grant, and then wait one year following the date of exercise before you sell, swap, or gift the shares, taxes are based upon capital-gains rates (maximum of 20 percent) rather than on the ordinary income-tax rates (maximum 40 percent).

Unfortunately, the tax complexity of ISOs does not stop at the holding-period decision.

The ISO's you exercise will most likely trigger what is called the Alternative Minimum Tax (AMT) in the year you exercise your ISOs.

The AMT is a separate parallel tax system that taxes a higher base of income at a higher flat rate and disallows many standard tax deductions you would normally get.

In summary, you can easily be put into a situation where you exercise an option at a certain share price, hold the stock rather than sell then at a premium, yet are subject to paying a flat 28 percent AMT on the difference between option value and market value on the day that you exercise the option. With the volatility of the stock market in the last year, this problem has been further magnified by the possibility that the share price at exercise may have been higher than the value at year-end.

The bottom line is that whether you have NSOs or ISOs, careful tax and cash-flow planning is needed before you make a decision on when and how to exercise the option.

DEFINE YOUR IDEAL "CONCENTRATED WEALTH." If you suddenly find that your stock options represent 50 percent or more of your net worth, and the ups and downs of the market make your balance sheet look like a yo-yo, you know what it's like to have concentrated wealth.

While the ride up with such a concentration is great, the ride down can be equally miserable. This is why it makes sense to monitor your balance sheet and establish guidelines and limits for how many of your stock options you are going to "let ride" and how many you are going to cash in for diversification purposes. For instance, a good general rule is to limit concentrated wealth in one company to 30 percent or less of your investment assets. This allows the 70 percent representing your diversified portfolio to be the critical mass of your net worth (and thus more stable). Yet your 30 percent of concentrated wealth will still offer significant upside growth potential if the stock options continue to increase in value.

MEET WITH A FINANCIAL ADVISER TO OPTIMIZE YOUR OPTIONS. Proactive financial planning is the best way to balance the tax and non-tax factors of your stock options. Simulate various alternatives on paper before you implement a strategy Make sure your simulation looks at the income tax, investment, retirement, cash flow; balance sheet and estate tax ramifications of all scenarios.

Limiting a decision to just one factor is where most mistakes are made.

Employee stock options are one of the most complex areas of personal financial management. If you are fortunate enough to receive options as a part of your compensation package, take the prudent steps necessary to fully integrate them into your long-term financial planning.

Joseph J. Janiczek, MSFS, ChFC, is the author of: "How to Achieve Absolute Financial Freedom."