I got a very interesting question in my inbox last week from a friend. And to be honest, I had to do a little research before I could give him a good answer. I’ve never worked for a company with options (or been high enough up to receive them) but they are a pretty nice benefit if you’re lucky enough to get them. Here’s the question I got:
Have some Qualcomm (QCOM) NQ options hanging out there. I have the cash on hand to exercise them, but no intention of selling them because I have no need for the cash influx. Does it behoove me to exercise and hold so that I can reduce my capital gains tax when I do ultimately sell them? Or are taxes always the same on options, i.e. the taxes are taken on the gain at time of exercise and not time of ultimate sale?
Basics of ISO
With ISO options, you can receive the more favorable long term capital gains tax rate if you hold them for one year after exercising the options. Generally you have 10 years to exercise the options (this is important). But your plan’s term may be slightly different (7-10 years is the norm).
So with ISO options, the amount of time you hold the options will have no impact on the tax treatment. Taxes won’t even come into play until after you exercise that option and decide to sell. If you were to exercise today at $30 and the stock price was $40, you would have to pay short term capital gains taxes (at your marginal rate) on that $10 gain but if you held the stock for a year you would be able to pay long term capital gains taxes (but your gain/loss might be a lot different) assuming the price remained the same for a whole year.
Holding the Options
You get the maximum benefit by waiting until the options are ready to expire. By waiting, you maximize your capital appreciation (or ‘time value’ of the options) and you’re also not paying taxes until the end.
Here’s an example:
If you use a strike/exercise price of $30 and a current stock price of $40 and you sell today, your gain would be $10. Assume 30% tax rate, you pay $3 in taxes and have $7 left over. If you invest that $7 and it compounds annually at 9%, you have $12.80 after 7 years.
If you decide to hold the option, let’s say your stock only grows at 5.5% for 7 years, it would end up at $72.73. You exercise and have a gain of $32.73. If you pay 30% in tax again, that is $9.82, leaving you with $24.55.
That’s double what you would have had even with a lower annual return. On average, you will be better served by holding on to your options until the end of the 10 years.
This analysis all depends on your financial situation though. If the options are a large portion of your net worth then it might make sense to gradually take some out (as long as the stock is doing well of course) to reduce risk. If not though, investment theory would dictate that your best chance for success/biggest gain is to hold them right up until the end since stocks tend to appreciate over time.
Not Enough Diversification for me
Once you exercise them, you can decide if you want to hold them for a year and sell to get LTCG or sell immediately and pay STCG. I am not a huge fan of individual stocks and I’m especially against investing in your own company’s stock since your entire income is also dependent on them. That’s too much exposure to company level risk IMO.
After you exercise the option, I’d probably see how things go and keep an eye on the price of the stock relative to the exercise price. If you’re in 25% federal tax bracket(this would also be your STCG rate) you’d pay 15% in LTCG if you held for a year. So if you decide to go for LTCG and hold for a year, you are betting that the stock won’t drop by 10%. I would probably hedge my bet and set a stop order at around a 3-4% loss. So if the stock drops by 3-4% from the exercise price within 1 year of redeeming the option, I would sell and pay STCG.
The stock could easily gain 10% and I’d miss out on that but it could just as easily lose 10%. I think of it as I’m already playing with house money, why not just cash out now and call it a day? This is the same strategy I used with my ESPP. Even though the stock went up even more after I sold it, I had still locked in a huge gain so I was happy.
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Readers, what do you think this reader should do with his options? Is there a good argument against holding them as long as possible that I missed? What would you do once it comes time to sell and pay STCG or hold for a year to try and get LTCG?
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