If you work for a successful company and have collected stock options as part of your compensation, you may be sitting on a highly valuable and concentrated asset. The question confronting you as your options vest is what to do with them.
Though you may be happy with the current value, as a financial advisor in Greenville, SC, we’ve seen how concentrated stocks options can actually present potential problems. Read this recent blog post to see what happened with Gary: Financial Horror Stories: The Greatest Threat to a Successful Retirement.
Risks of Concentrated Stock Options
A position is concentrated if it constitutes a significant portion of your portfolio. There is no magic percentage that makes a position concentrated. Rather, you would judge a position to be concentrated if your wealth would be substantially impacted by the position suddenly losing value.
That is, in fact, one of the primary risks of holding concentrated stock options. It’s a classic case of putting too many eggs in one basket. If you could suffer the loss of the position without it affecting your current or future lifestyle, then the importance of this risk is minimal. On the other hand, if a loss would negatively impact your future plans, then the concentrated position is too risky to leave unresolved.
Let’s take a look at some of your options.
Sell Your Shares
If you exercise your options and sell the stock, you’ll earn a capital gain equal to the sale price of the shares minus the purchase price of the options (including options you received for free). You’ll have to pay capital gains tax on the sale profit that may also push you into a higher tax bracket. That means you’ll pay more on your other income than you would have, had you not sold the concentrated position.
You might be able to arrange the tax selling of other positions that are experiencing a loss, thereby offsetting some of your large capital gain. The risk there is that you might be selling your losing positions prematurely just to take advantage of the offset, thereby missing out if they should recover.
The positive aspects of selling your shares are that it removes their downside risk from your portfolio and provides cash you can use to diversify your holdings. Both consequences significantly reduce your investment risk. Of course, you can use the proceeds however you wish, like buying a boat or retiring early. I’d count that as a positive outcome as well. This can be an especially helpful strategy if you got a late start to your retirement planning.
Whatever you choose to do, talk to a fiduciary financial advisor first to ensure you understand the impacts of your decision.
Hedge Against Risk
If you choose to hold your shares instead of selling them, you’ll continue to expose yourself to downside risk. You can hedge against that risk by buying puts on the shares, giving you the right, but not obligation, to sell shares at a given price (the strike price) on or before the put option’s expiration date. In effect, puts lock in a selling price that protects you from downside moves below that price.
Like all insurance, put-buying requires you to pay a premium, which is just the market price of the puts. Your potential return is the puts’ strike price minus the premium.
Regularly buying new puts after the current ones expire can become expensive very quickly, even if the hedge is only partial. You may end up spending a lot to protect your concentrated position, which ultimately reduces their economic value to you.
Once again, talk to a fiduciary financial advisor to determine what makes the most sense for your situation. At Global View, we can help you with your portfolio as well as tax planning and how your options affect your overall retirement plans. Schedule a no-obligation conversation to see how our team of financial advisors in Greenville, SC can help.
Donate Your Shares
If your concentrated position is “found money” whose loss would not significantly impact your overall wealth, you might consider donating the shares to a tax-qualified charity. You’ll earn a tax deduction and shift the position’s downside risk to the recipient.
If you have children or grandchildren, you might consider gifting at least some of the position to 529 Educational Savings Plans. You can contribute $15,000 per year per child, and you can make a five-year contribution of $75,000 per child all at once. Your spouse can make equal contributions. These contributions, while not deductible at the federal level, may qualify for state tax deductions, depending on where you live. For more about what this looks like in the Carolinas, the team at Global View can help. Let’s talk!
Use It to Generate Income
You can use your concentrated share position in a couple ways to generate income. First, you’ll receive any dividends paid out on the shares. You can also write covered call options on your shares, thereby collecting a premium. These calls can be exercised by the buyer if the underlying share price is higher than the call’s strike price. However, if the shares don’t reach the strike price before the options expire, you get to keep the shares and, if you choose, sell another set of covered calls. In any case, you pocket the premiums you generated by selling the calls.
Exchange Your Shares
One interesting way to handle your concentrated position is to swap it for shares in a pool of various concentrated holdings, known as an exchange fund, not to be confused with an Exchange Traded Fund or (ETF). In an exchange fund partnership, investors with concentrated positions in a single stock, pool their shares and receive fund shares in exchange. The fund shares replace the investors’ concentrated positions with diversified ones, thereby lowering overall risk. The exchange of shares defers taxes, which benefits shareholders who would otherwise have sold their concentrated positions and triggered taxes. There may be a requirement for potential shareholders to have a set amount of liquidity before they can join the partnership, so make sure you understand the rules before making a decision.
The downside of private exchange funds is their lack of liquidity – there is no guarantee there will be a buyer available when a fund shareholder wants to cash out their shares, and the 20 percent held in illiquid assets intensifies the liquidity problem. Moreover, the fund usually has a lockup period prohibiting the sale of fund shares for a specified time.
How Global View Can Help
Clearly, concentrated stock options present both opportunities and challenges to investors. If you’d like help integrating these options into your overall financial plan, talk to the team of fiduciary financial advisors at Global View. As a family office style firm, we have Certified Financial Planners (CFPs), an accountant and an estate planning attorney under one roof who have experience working with concentrated stock options. Our team can provide you with detailed advice customized to your unique needs. This can make a big impact on your future.