Exercising Stock Options: Key Financial Planning Considerations

Valuing stock options and determining when to exercise can be complicated. In our last Viewpoint, An Evidence-Based Approach to Stock Options, we explored our valuation methodology and introduced the “Truepoint Ratio” as a decision-making tool. While the Truepoint Ratio provides great insight, any decision to exercise an option should be made in a broader context.

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, other critical components include cash flow needs, tax strategy, and projected impact on the client’s overall financial plan. How these factors should be weighted in the exercise decision will be driven by the individual circumstances.

Cash Flow Needs and Exercising Stock Options

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 that cash to avoid early IRA withdrawals and associated penalties. Another could be the purchase of a new home with the option proceeds contributing to the down payment. While this certainly limits flexibility, and negates any further growth potential of the options, securing upcoming cash flow may be an absolute priority.

If near-term cash needs do not exist, we then consider the impact these options have on the overall financial projection. If our analysis indicates that the option exercise is not significant to the long-term projection, then the flexibility exists for investment valuation, tax impact and risk preferences to drive the decision. However, if the inflow of option income has a material impact on the long-term success of a client’s plan, this will influence our recommendation. For example, we may lower our targeted Truepoint Ratio if we determine that a decrease in the stock price would materially impair the ability to reach their financial goals.

Strategic Tax Planning

Finally, the end of a tax year can introduce greater flexibility for strategic tax planning. 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 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 Truepoint Ratio and the financial planning variables to make a recommendation.

As this discussion indicates there are many factors to consider in evaluating stock option exercise, and each situation is unique. This is just one example of why we believe strongly that clients are best served by a truly integrated and holistic approach to wealth management.

Truepoint Wealth Counsel is a fee-only Registered Investment Adviser (RIA). Registration as an adviser does not connote a specific level of skill or training. More detail, including forms ADV Part 2A & Form CRS filed with the SEC, can be found at TruepointWealth.com. Neither the information, nor any opinion expressed, is to be construed as personalized investment, tax or legal advice. The accuracy and completeness of information presented from third-party sources cannot be guaranteed.

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