Exercising Stock Options: Key Financial Planning Considerations
Valuing stock options and determining when to exercise can be complex and can depend on each client’s unique financial situation. When we sit down as a team to evaluate a client’s stock option exercise strategy, we review their situation from several perspectives. In addition to the investment valuation of the option grant like the current stock price and expiration date, it’s important to also consider cash flow needs, how the decision fits into the client’s overall financial plan, and the potential tax impact. The weight given to each of these factors in the stock exercise decision will depend on an individual’s specific circumstances.
Cash Flow Needs
The first point to consider is whether an immediate cash need exists. If so, this could override all other parts of the decision-making process. One example would be using the cash from a stock exercise to fund living expenses to avoid early IRA withdrawals and associated penalties. Another example could be using the proceeds to help fund a down payment when purchasing a new home. While this first point to consider can limit flexibility and negate any further growth potential of the options, securing upcoming cash flow may be an absolute priority.
Financial Projection
If near-term cash needs do not exist, we then consider the impact these stock options have on the client’s overall financial projection. If our analysis indicates that the stock option exercise is not significant to the success of the long-term financial projection, then the flexibility exists for investment valuation, tax impact and risk preferences to drive the decision. However, if the inflow of stock option income has a material impact on the long-term success of a client’s plan, this may influence our recommendation. For example, we may recommend exercising a stock option sooner rather than later if we determine that a decrease in the stock price would materially impair the ability for a client to reach their financial goals.
Strategic Tax Planning When Exercising Stock Options
Finally, if there’s no immediate need for cash and the impact on the client’s overall financial plan is minimal, we focus on strategic tax planning when evaluating stock option exercise decisions. If a client’s income level and/or marginal tax rate is likely to decline in the next tax year, the small timing risk of deferring exercise to the following year could result in significant tax savings. However, the more time between potential exercise and the end of the tax year, the more we will rely on the factors listed above and the financial planning variables to make a recommendation.
As evidenced in this discussion, there are many factors to consider in evaluating stock option exercises, and each client’s situation is unique. This is just one example of why we strongly believe that clients are best served by a truly integrated and holistic approach to wealth management.
