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August 28, 1999 Probably the best way to invest in the stock market is through employee stock options, if you're in a position to merit them as part of your compensation. Usually the way it works is that you are granted a certain number of options when hired, with more granted each year you stay. These give you the right to buy a certain number of shares of the company stock at a strike price set to equal the current market price, and this right lasts for typically seven years. You vest in the options over a period of years (vest means when you are allowed to cash them in). If you quit, you lose your unvested options. If the price goes down, your options are worthless, but if it goes up, they are each worth the difference between the current market price and strike price. Of course, the first and most important thing is that the company stock must go up. If it doesn't, you can (and should!) vote with your feet and leave for another job. But assuming your options are worth something, you are faced with a choice: cash them in, keep them, or convert them to stock (cash them in and buy stock with the proceeds). If you're bearish on the stock, you should cash them in, of course, but if you're bullish, should you convert them to stock? A reader writes with this question: "Some people cash in their options immediately as they vest on the theory that it is better to pay capital gains than to pay straight income. I tend to be of the mind that having capital is goodness, and it is better to have lots of income and pay the taxes on it. Is it better to wait until the last day of the seven year vesting period and pay full income tax, but getting the use of the money, or is it better to cash in earlier and have the bulk of your appreciation as capital gains?" Here's my answer. In favor of converting is the fact that for most people in the U.S., the tax rate on capital gains is lower than the tax rate on straight income (which is what you get when you cash in options). Two factors favor keeping the options. One key difference is that with options you have more leverage than if you cash them in. Another key difference is that if you keep the options, you have more capital working for you, because it hasn't been reduced by taxes yet. Here is an example: Let's assume a capital gains tax rate of 20% and an income tax rate of 40%, for the sake of simplicity.
--versus--
So if you're bullish, stick with the options. The difference in tax rates won't make up for the loss in leverage. As your strike price becomes less and less a fraction of the stock price, converting to stock looks a little better (because the difference in leverage is less). The example:
--versus--
But notice that delaying paying the tax man still outweighs the capital gains tax advantage. In case you think a more extreme example would show the advantage of converting, lets assume a strike price of zero and after converting run the price up a hundred-fold to $10,000 a share. We start with a thousand at $100, worth $100,000. If the price rises a hundred-fold to $10,000, the options will be worth $10,000,000. Pay Uncle Sam 40% income tax and we're left with $6,000,000. If instead we convert our thousand at $100, we pay the 40% income tax, leaving us with $60,000 to reinvest in 600 shares. Now the hundred-fold rise makes our shares worth the same $6,000,000. But here's the kicker: since we converted we now owe 20% capital gains tax on the profit ($5,940,000) which leaves us with only $4,812,000 after tax. So my advice is to keep the options as long as possible (while you're still bullish, of course). You can't avoid the income tax, but you can avoid (or at least delay) the capital gains tax. Don't think of the capital gains tax as a lower tax, think of it as an additional tax. Friday's close: Dow 11090, S&P500 1348, NASDAQ 2758 All-time High: Dow 11326, S&P500 1418, NASDAQ 2864 Sept '98 Low: Dow 7539, S&P500 956, NASDAQ 1375 During the last few months, the Dow stayed above 10,000 but the high flying Internet stocks took a big hit. They're still quite a bit below their highs, while the rest of the market is steaming along and is now just off recent all time highs. As a fundamentalist, I say the market is over priced, but you have to remember that it can stay that way for years. Of course, the day of reckoning will come. © Copyright 1999 by Richard Gillmann. All Rights Reserved. |