Don't burn those shrunken-value stock options just yet

PERSONAL FINANCE

March 11, 2001|By EILEEN AMBROSE

A YEAR AGO when the market was hot, many workers were happy to accept lower pay as long as it came with generous stock options.

Options allow employees to buy, usually over 10 years, a certain amount of their employer's stock for a set price. Some workers, particularly those at high-flying, high-tech companies, got rich by purchasing company stock for far less than what it was trading for on the open market.

But now the market has lost steam. Many workers see that their options are worth a lot less today and may wonder what to do.

Financial experts say there are some option strategies to take in a down market. The best move for you, though, depends on your company's prospects, when the options expire, and many other variables.

The first step is to know whether you have nonqualified or incentive options.

Rank-and-file workers generally receive nonqualified options. When exercising these options - or, rather, when you buy the stock - the difference between what you paid and the stock's current market price is treated as ordinary income and taxed as such.

Keep the stock for at least a year and, when you eventually sell it, you will owe long-term capital gains tax on any appreciation above the market price of the stock on the day you exercised the option.

Incentive options tend to be awarded to upper management. These options don't trigger income tax when exercised. You're taxed when you sell the shares - either at your ordinary income rate or at the capital gains rate if you hold them long enough.

This can be a big savings, considering the top income tax rate is 39.6 percent and the top long-term capital gains rate is 20 percent.

Something to watch out for: Incentive options can trigger the alternative minimum tax. The AMT, generally 28 percent, was designed to capture the rich who are avoiding taxes. But many less affluent families with options are caught by the tax.

Once you understand the type of options you have, experts recommend some of the following strategies in a down market:

Ride it out. Sure, the market is down now, but if you're options aren't expiring soon, wait out the slump, said Meg VanDeWeghe, executive in residence with University of Maryland's business school.

"All else being equal, the best strategy is to hold them as long as possible," she said.

You still have the opportunity to buy the stock if it goes up later. But by waiting, you don't have to put up money to buy shares and, in some cases, pay income tax, VanDeWeghe said. Meanwhile, that money might be better invested elsewhere, she said.

Of course, there are times to exercise options early, she added. Perhaps you're switching jobs and will forfeit any unexercised options when you leave, or your portfolio has so much company stock that you want to sell some of your option shares and invest the proceeds elsewhere, she said.

Exercise options and sell the shares immediately if you think the stock is overvalued and will tumble before your options expire, she said.

Play the tax advantages. If you must exercise options in a down market, there are some advantages taxwise if it's a stock you want to keep, said Sue Stevens, director of financial planning for Morningstar, a mutual fund tracking firm in Chicago.

If the stock price has fallen, the amount of income you'll gain from exercising nonqualified options will be lower, too, and that means a smaller tax bite, Stevens said. And if the stock is held long term, any future appreciation will be taxed at the lower capital gains rate.

If you have incentive options, you can also exercise more shares before coming up against the AMT, she added.

Give them away. Some companies allow employees to transfer nonqualified options to others, say, children or charities.

This can be a useful tool for those who want to reduce their taxable estate, said Thomas Grzymala, a financial planner with Alexandria Financial Associates Ltd.

Once given away, the options and any future appreciation are out of your estate.

There's an added benefit to giving away options when the stock price is temporarily down, Grzymala said. You can give up to $10,000 a year to another person without triggering gift taxes. But if the stock price is depressed, you can give away more option shares before hitting the threshold than if the price were higher, he said.

Be aware that the new owner controls the options and decides when to exercise them. Also, because these options are considered compensation to you, you will pay whatever income tax is due when the options are exercised, Grzymala said.

Ask for more. "If you really believe in the company's prospects, you should be actually trying to get more options," said David Gumpert, author of "Better than Money: Building Your Fortune Using Stock Options and Other Equity Incentives - in Up and Down Markets."

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