NQ Stock Option Exercise/Sell Strategy Help

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dharmachic
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Joined: Fri May 11, 2012 1:04 am

NQ Stock Option Exercise/Sell Strategy Help

Post by dharmachic » Thu Feb 13, 2020 10:20 pm

I would like some help with developing a stock option exercise/sell strategy, with a focus on minimizing my tax burden as much as possible.

I live in California and work for a public REIT, and received the following stock options:
10,000 NQSO / Grant price $16 / Granted 2014, expire 2024 = 10,000 vested (fully vested)
2,000 NQSO / Grant price $23 / Granted 2017, expire 2027 = 1,000 vested

Current stock price is $28, and I believe that it will continue to go up, but would like to start selling shares for diversification purposes and because the market is unpredictable.

Due to my current salary, and a perhaps rash decision in January to exchange all my Vanguard Lifestrategy Growth Fund (VASGX) shares with Vanguard Large Cap Index Fund (VLCAX) shares in my taxable account to reduce my ordinary dividend burden, I'm looking at around $20,000 capital gains this year which may put me right at the upper edge of my 24% tax bracket.

I'd like to put a plan in place to start exercising my stock options, and hold for a year before selling to take advantage of the capital gains tax. However, I'm not adverse to just exercise and sell immediately either. I don't need the funds right now, and plan to move everything to my taxable account in an index fund.

I've seen some guidance to exercise/sell 25% or a certain portion every year/every quarter, but I'm not sure what would be right for my situation.

I may be receiving more stock options in the future, so that's another reason I want to divest from having a significant portion of my portfolio in a single company stock. Also, I started working later in life and am trying to catch up on saving for retirement, so donating shares to charity would not be a preferable option. I'm ok with paying the taxes I owe, I just want to be intentional and not pay more than I have to because of a failure to think this through.

Any suggestions would be much appreciated. If I have left out pertinent information, please let me know.

Thank you!
dharmachic

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mhc
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Re: NQ Stock Option Exercise/Sell Strategy Help

Post by mhc » Fri Feb 14, 2020 9:23 am

You should read up on how NQSO are taxed.

Exercising is a taxable event regardless of what you do with the share you have after the exercise. The difference between the exercise price minus the grant price times the number of shares will count as ordinary income. When you dispose of the shares, then you encounter cap gains.

Many people, including me, do a cashless exercise and sell immediately. Some of the exercised shares are sold immediately to cover taxes. Otherwise, you have to send a check for the taxes. Selling the remaining shares immediately results in an extremely small short term cap gain/loss.

Options have intrinsic and extrinsic value. The fair market value minus the grant value is the intrinsic value. The extrinsic value is primarily based on how much time is left for the option and how deep into the money the option is. I try to exercise my options once there is very little extrinsic value left or I have a need for the money.

kaneohe
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Re: NQ Stock Option Exercise/Sell Strategy Help

Post by kaneohe » Fri Feb 14, 2020 9:43 am

agree w/ mhc about the taxation issue. When you exercise , the bargain element is subject to ordinary income tax.
The basis for the shares are the price on the date you exercise. If you sell immediately, there will be a near 0 gain on the shares so there is no advantage to holding the shares for one yr . You could just as well reinvest the proceeds in a low cost index fund , get diversification, and get the same LTCG treatment after 1 yr.

knowledge
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Re: NQ Stock Option Exercise/Sell Strategy Help

Post by knowledge » Fri Feb 14, 2020 10:33 am

Right. There is no way to turn profits from NQSOs into long term capital gains. The intrinsic value of those options would be taxed at normal income rates and would be reported on your W2. So forget about exercising and holding for any tax benefit.

As you note, you can decide what tax year to take this income, but that is obviously subject to volatility on the stock price as it moves over time. There are many considerations - current income, future projected income, future stock price, asset allocation - there is no right answer. Broadly, long dated call options have a lot of extrinsic value due to their time horizon. But that must be balanced against the fact that you could be left with zero at any moment.

Topic Author
dharmachic
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Re: NQ Stock Option Exercise/Sell Strategy Help

Post by dharmachic » Fri Feb 14, 2020 3:19 pm

Yes, I neglected to mention in my initial post that I am aware of the fact that I will be taxed at ordinary rates when I exercise, and again based on the profits between exercise and sell, when I sell. The tax at exercise is what concerned me since that may push me into the next tax bracket.

So if I understand cashless transactions correctly, I am essentially prepaying the taxes owed at exercise when shares are withheld for payroll taxes at the time of exercise, so that I don't have to write a check to the IRS. At what ordinary tax rate? 25% like bonuses, and then it's adjusted when I file my taxes?

I need to read up more on the time premium (extrinsic value), as my natural inclination is not to leave it up to the market but divert the cash to my index funds. Bird in hand is worth two in the bush and all that. I need to understand more how I am penalized more by exercising early, but it's hard to wrap my head around this. Is it just the potential appreciation?

Is there a general strategy to strike a happy medium to balance out the risk? Such as sell half now and half before expiry (assuming that I have no immediate cash needs and it's all going towards retirement) as long as your tax bracket is between this and this? Or exercise/sell just enough to get your company stock position to under 20% of total portfolio?

I'm not looking for specific solutions, just some guidance at some options that one would consider other than wait to exercise until just before expiry.

I appreciate the responses so far and the help!

Dharmachic

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mhc
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Re: NQ Stock Option Exercise/Sell Strategy Help

Post by mhc » Fri Feb 14, 2020 3:42 pm

When I exercise NQSOs I get to choose the withholding rate. I don't know if your brokerage has that or not. Otherwise, it will probably be 25%. Everything gets squared up when you file your tax return.

Strategies are all over the place for when to exercise options. They can definitely impact tax rates. That is just the system we live in. More you make, the more you pay.

I try to extract 80-90% of the extrinisic value. Some people sell as soon as they vest. Others wait until they are about to expire. It's all a roll of the dice which method will be best. You have to figure out what works for you and go with it. There are times you will look brilliant, and there will be times you look like a fool.

Long ago, I was waithing for a grant to hit $100k in the money before I exercised. It came within a few hundred dollars, but I really wanted to hit $100k. The market crashed. When I exercised, I think I got about $10k. It was an expensive lesson for me.

kaneohe
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Re: NQ Stock Option Exercise/Sell Strategy Help

Post by kaneohe » Fri Feb 14, 2020 5:13 pm

dharmachic wrote:
Fri Feb 14, 2020 3:19 pm
.........................................................

So if I understand cashless transactions correctly, I am essentially prepaying the taxes owed at exercise when shares are withheld for payroll taxes at the time of exercise, so that I don't have to write a check to the IRS. At what ordinary tax rate? 25% like bonuses, and then it's adjusted when I file my taxes?

...................................................

Dharmachic
In a cashless transaction, you are also paying the exercise price of the option so you don't have to come up w/ cash to exercise.

I guess any strategy involves consideration of how the exercise will affect your tax bracket and whether you want to be the hero/goat to maximize your gains at the risk of having none. If you are are an index fund investor, sounds like you might want to do some time diversification in exercising so that you end up somewhere between goat and hero unless you have a crystal ball about how the company/stock will do in the future.

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