Ah, options, so nice and confusing

PERSONAL FINANCE

March 26, 2000|By Eileen Ambrose

You don't have a corner office or a key to the executive restroom, but you may have something once reserved for top management: stock options.

In today's tight labor market and competitive environment, more companies use stock options to recruit, retain and motivate employees at all levels. Seven to 10 million workers are eligible for stock options, compared with about 1 million a decade ago, according to the National Center for Employee Ownership.

That means more of us will be wondering what to do with them.

It's a question being weighed by employees of Times Mirror Co., including those of The Sun, who must make choices on their options now that their employer is being acquired by the Tribune Co.

A stock option is the right to buy a certain amount of company stock for a fixed price over a limited period, usually 10 years.

For example, you may be granted an option to buy 100 shares at $10 each. Then you hope the stock goes up. If it does rise to, say, $25, you can exercise the option -- or purchase the stock -- and realize a gain of $15 per share.

"The worst thing that happens is the price doesn't go up and -- the option expires worthless," said Andrew Goldstein, a senior consultant with Watson Wyatt Worldwide, a benefits consulting firm.

There are two kinds of options: nonqualified and incentive.

Nonqualified options are more common. Companies like them because they get a tax deduction when employees exercise them.

Incentive stock options, often awarded to executives, offer more tax advantages to recipients.

At the time you exercise nonqualified options, you will owe ordinary income tax on the difference between what you paid for the stock and its current market price. You also will pay Social Security, Medicare and state taxes on that spread, experts said.

Often, employees will sell the stock immediately after exercising nonqualified options, keeping their tax bite limited to the income tax.

What happens if you convert your options into stock and hold it for a year or more? You'll still owe the income tax. And when you eventually sell the stock, you also will owe long-term capital gains tax on any appreciation between the market price on the day of exercise and the eventual sale price.

Incentive stock options, or ISOs, don't trigger income taxes at the time they're exercised. If the shares are held for two years after the option is granted and one year after the exercise date, any gain at the time of sale is taxed as a capital gain.

"That can be a substantial savings for people," said Kimberly Keller, a financial planner with Baltimore-Washington Financial Advisors in Ellicott City.

Of course, while holding the stock for a longer period to be eligible for the lower tax, these stockholders run the risk that the stock may decline in value. Also, if they sell the stock before the time limits are up, the gain will be taxed as ordinary income.

Another caveat with ISOs is that by exercising them, you can trigger the alternative minimum tax, or AMT, financial planners warned.

The AMT was "meant to tax the rich who otherwise would slip through the loopholes," said Sue Stevens, director of financial planning for Morningstar Associates in Chicago. "When it gets to ISOs, it's no longer the rich; it's everybody."

The AMT comes into play when there's a sizable spread between what you pay for the stock and its market price at exercise, Keller said. Before exercising ISOs, consult with a tax or options expert to find out how many shares you should exercise to keep your tax hit at a minimum, she advised.

While taxes are an issue with options, they shouldn't be your main consideration, experts said. "You can't let the tax tail wag the dog," said David Root, chief executive officer of D. B. Root & Co. in Pittsburgh.

You need to consider the company's prospects and how its stock fits in your entire portfolio, experts said. Does the stock have the potential to rise and, therefore, is worth keeping? Or, is the outlook poor, or too volatile for you, and you're better off selling the stock and investing the proceeds elsewhere?

"You need to approach it as an investor making an investment decision," Root said. "That means doing your homework, looking at it almost like a securities analyst would."

Root recommends going to the library to read research reports by Value Line and Standard & Poor's to find out the prospects for your employer and its stock. Another resource is www.morningstar.com, which grades companies on their profitability, growth, financial stability and valuation, said Stevens.

Whether you hold or sell the stock also will be determined on how much time you have to ride the ups and downs in the market, Keller said.

"If you're approaching retirement or leaving the company, you can't afford to wait and see what happens to the stock," said Keller. In that case, you might be better off selling the stock and salting the money away in other investments, she said. And make sure you're diversified, experts advised.

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