If you’re concerned about such a severe drop in the value of your options, it may be time to consider a reallocation. If you find yourself in retirement without having previously reallocated your stock options, the decrease in stock price may mean a necessary but significant reduction in annual retirement spending.
Consider Taxes and the Type of Options You Have
There are three items commonly discussed when considering how stock options fit into a retirement plan.
- Taxes
- Financial planning
- Investment risk tolerance
- While I can easily argue that all three should be equally considered, most of the conversation tends to center around tax planning.
How your stock options are taxed is critically important. In fact, how your stock options are taxed may have a material impact on the money you have available for retirement.
When it comes to taxes and stock options, you need to know if you have non-qualified stock options or incentive stock options.
Non-qualified stock option gains are taxed as ordinary income when exercised.
Incentive stock option gain is significantly more complicated as it can be taxed as ordinary income but may also be taxed at preferential long-term capital gains. Incentive stock options are also potentially subject to the alternative minimum tax.
While the details of this conversation are beyond this article, the after-tax value after exercising and selling the shares may make a considerable difference in the spendable value of your nest egg in the future. Make sure you take taxes into account as you build out your retirement plan if you plan to leverage stock options as part of it.
Plan for Stock Options Beyond Your Retirement Date
Retirement planning doesn’t end once you retire. It’s an ongoing process that you’ll continue to undertake even as you begin to enjoy your life after your career.
And when you have stock options, an important planning question that will come up as you prepare to make the transition is what happens to unvested and/or unexercised shares at retirement?
Will your unvested shares be forfeited when you retire? If so, are you sure you have not included the value of your unvested shares in your retirement calculations?
For example, what if you have stock options with a current value of $2,000,000. But what if $500,000 of this value is “in-the-money,” but unvested stock options? At retirement, it’s very possible you could forfeit $500,000 of value. Have you considered the impact to your retirement $500,000 of this value disappears due to the forfeiting of $500,000 of unvested value? You should also take notice of your unexercised incentive stock options
Incentive stock options often need to be exercised within 3 months of termination (or in this case, retirement) to retain its status as an incentives stock option. If you are required to exercise these shares, the cost to do so may be expensive. The simple math is the value of the shares exercised multiplied by the grant price. Can you afford the cost of exercising and holding the options? Or will you need to do a cashless exercise? A cashless exercise is a strategy that requires no out of pocket cash to exercise. Instead, some of the exercised shares are immediately sold to cover the cost of the other shares.
Related: Financial Planning for Employee Stock Options
The exercise of incentive stock options can also impact your alternative minimum tax bill the following April? The spread between the grant price and the exercise price (multiplied by the number of shares exercised) is a preference items for AMT calculations. A large bargain element may mean a significant tax bill.
Finally, is exercising and holding more shares, furthering increasing your single stock position, something you should be doing as you enter retirement?
Further strategic planning for stock options may consider calendar years in retirement when taxable income is lower. Lower tax years can create opportunities to exercise and/or sell shares in a way that minimizes the taxes you owe.
In fact, strategically selling the “right” stock options may have a materially different tax implication. For example, exercised and held incentive stock options have “dual basis.” One basis for regular tax and one basis for AMT. If you have multiple tranches of exercised and held stock options, its very likely the spread between is different. Incentive stock with a greater spread may be more advantageous to sell in an effort to accelerate AMT credits, leading to a potentially smaller tax bill.
Ultimately, spreading the tax hit can be a good thing. But you also need to balance your tax obligations with that fact that waiting to sell your shares leaves you in the potentially unenviable position of retaining a concentrated equity position.
How to Think About Stock Options and Retirement Planning
Stock option can be great. But retirement planning may warrant a change in thinking.
In your working and saving years, it could be reasonable to assume some degree of overexposure risk in exchange for the opportunity to generate wealth through stock options.
This makes the most sense when you’re employable, earning a working wage, and/or willing to accept the risk. During this accumulation stage of life, stock options, even concentrated equity, can be a positive thing as you are not dependent upon this wealth to live your life.
Retirement often comes with a change in thinking, primarily driven by the need to switch from accumulation of wealth (saving) to decumulation of wealth (spending). In the decumulation stage of life, wealth generation (concentrated equity) make take a back to seat to ideas such as asset allocation and diversification.
Furthermore, investment risk tolerance may change in retirement, leading to a desire to decrease expected volatility from the portfolio to make room for stable income generation.
To start thinking about retirement planning and stock options strategically, you’ll want to ask and answer questions such as:
- How do you know when it’s the right time to sell your stock options?
- How do you know if (or when) it’s okay to hold stock options in retirement?
- If you do sell stock options, what should you do with the cash?
- How do you actually get money from your investment portfolio and accounts to fund your retirement?
- What are the tax implications and ramifications of selling stock options?
While there is no perfect answer for the when, the how, and the time to transition from accumulation to decumulation, there are conversations that should be held in regards to risk profile, income needs, retirement expectations, and total wealth goals.
These conversations can be combined with tax planning, investment planning, and estate planning to produce a plan for your stock options in retirement.
Feeling overwhelmed? That’s reasonable, as this is complicated, complex planning. So one final question to consider asking might be this one: when is it time to reach out to a professional financial planner to seek help? If you’re curious about learning more, start here.
This article has been republished with permission from Daniel Zajac.