You can’t afford to make poor decisions about incentive stock options

Pam Kreuger Contributor

Pam Kreuger is the founder and CEO of Wealthramp.com, a free online service that matches consumers with qualified, fee-only financial advisers, and the creator and host of the investor-education television series “MoneyTrack.”

John Chapman Contributor

John Chapman is a certified financial planner professional with WorthPointe Financial Planners in Newport Beach, California, and a fee-only fiduciary adviser on the Wealthramp network.

One of the big reasons you’re giving 110% of your talent and effort to your private company is because you’re hoping to eventually cash in on all those vested incentive stock options (ISOs) that have been sitting in some account, waiting for the day your company goes public.

There’s nothing wrong with that. Who doesn’t dream of reaping an options windfall and using it to retire early, buy a house, pay off their college loans, travel around the world or become a full-time philanthropist?

Unfortunately, when it comes to figuring out how to cash in their stock awards, most employees are on their own.

Their employers can’t always provide the answers they need — especially when the questions relate to personal finances. Most companies admit they need to be better at explaining how ISOs work in general, but they can’t legally work one-on-one with employees to help them exercise and sell shares the right way.

Most companies admit they need to be better at explaining how ISOs work in general, but they can’t legally work one-on-one with employees to help them exercise and sell shares the right way.

That’s why, when the time is right, many employees actively look for help from a qualified fiduciary financial adviser who can walk these could-be “options millionaires” through various cash-in scenarios.

Here’s a real-life example (using a pseudonym).

Kurt is a 50-year-old VP of product management at a healthcare startup that just went public. Over his three years with the company, Kurt had amassed 350,000 ISOs worth approximately $6 million. Unlike many options millionaires, he didn’t intend to cash in everything and retire early. He planned to stay with the firm but wanted to liquidate enough ISOs to pay for a vacation home and add greater diversification to his investment portfolio. This presented significant tax risks that Kurt wasn’t aware of.

If Kurt exercised his ISOs and sold the shares before a year had passed, his profits would be characterized as short-term capital gains, which are taxed as ordinary income.

To illustrate the potential tax implications of this action, we created a hypothetical scenario that showed if Kurt exercised all of his ISOs and sold the shares immediately, he would incur approximately $6 million in ordinary income, which would push him into the top tax bracket and put him on the hook for almost $3 million in combined federal and state taxes.

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