Sign up for the Globe Advisor weekly newsletter for professional financial advisors on our newsletter sign-up page. Get exclusive investment industry news and insights, the week’s top headlines, and what you and your clients need to know.
With stock markets on a steep slide this year, is this an opportunity for employees with in-the-money stock options to exercise them, pay less in taxes and reap the benefits in the future?
Most of the time, employees exercise stock options when their company’s stock price is at a peak to benefit from the wider spread between the exercise price and the current fair market value of the shares.
But when markets have fallen, there’s a way for stock option holders to gain from that dip in price, financial advisors say, but each individual’s situation is unique.
There are four main strategies employees use when exercising stock options, which is the right to buy a certain amount of their company’s shares at a set price, says Sami Nathoo, senior financial planner with Patrimonia Gestion Wealth at Raymond James Ltd. in Montreal.
The first strategy is to exercise stock options and hold on to the shares, hoping the stock price will rise and they can sell it later at a higher price, or keep the stock for the long haul. This requires investors to have the cash available to buy the stock at the option exercise price and pay any related taxes.
The second strategy is the “cashless” way to exercise stock options, which can be done when there’s a wide spread between the exercise and market price. The employee exercises the options and sells enough of the stock immediately to fund the purchase of the shares and taxes. Then, they hold on to the rest of the stock hoping the price rises further.
In the third case, they exercise options and sell all the stock purchased simultaneously to cover the cost of buying the shares and taxes and then use any additional cash to fund their lifestyle.
The fourth case is the worst-case scenario in which they exercise the stock options but hold on to them for the long term and the share price falls instead of rises, he says.
So, with stocks sliding, is now a good time to exercise employee stock options? In real terms, exercising stock options when a company’s shares aren’t at their peak means the investor gains less from the sale of their options – but also pays less taxes. And if they hold on to the stock, they may be able to sell it for a higher price when the market recovers.
“The option to exercise at a lower fair market value is less about taxes but more of a market prediction question,” Mr. Nathoo says.
“[Clients] should have a discussion with their advisor to consider the current market valuation, see where the company is right now, and [estimate] the potential future value.”
If the investor is going to sell at a higher price, they may potentially have to pay higher taxes, but they may have a higher net income, which could potentially benefit them more, he adds.
Tax implications of exercising stock options
When an employee exercises their stock options, they’re taxable as employment income usually in the year in which they’re exercised, although they’re taxed at different times if their employer is a publicly traded or private company in Canada.
Employees may qualify for a stock option deduction equal to 50 per cent of the benefit. Stock options granted prior to July 1, 2021 are eligible for this deduction with no cap on the number of options that qualify. But there is an annual cap of $200,000 for stock options granted after that date.
If employees sell in a down market and use the share sale to pay for the purchase and taxes and hold on to the remaining shares, “the downside of selling in that type of market … is that you may potentially have to sell more shares [to cover costs] and have less to hold for future gains,” Mr. Nathoo explains.
“Ideally, you want to try to exercise when you’re in a lower income tax year so that you don’t get penalized too much.”
Ultimately, don’t try to time the market, he adds.
When to exercise stock options is a complex question and depends on the individual, says Ida Khajadourian, portfolio manager and investment advisor with Khajadourian Wealth Management at Richardson Wealth Ltd. in Toronto.
It depends on whether the options are in the money; if the funds are needed now; whether the shares will be held or sold; if a portfolio is diversified; if it’s believed the stock price will rise; if the options are about to expire; if the holder plans on staying with the company or leaving and their tax bracket, she explains.
With the market down, investors can benefit by exercising stock options now and then holding on to the shares expecting them to recover and rise more in the future, Ms. Khajadourian says.
“So, in that scenario, it could be a good time, but you have to look at liquidity and if you have the ability to do that,” she explains. “That would make sense if you’re in a financial position in which you’re not making this decision because you need that money.”
With the spread between the exercise price and current stock price being less, “there’s that smaller difference and a lower tax bill, and then [they can] sell the stock in the future when the market recovers. But there’s risk with that too,” she says as the company could run into hard times and the stock price may not rise as expected.
“You would want to be confident that the company is moving in the right direction and you’re in it for the long term,” Ms. Khajadourian adds.
Having discipline, striking a balance
Trevor Fennessy, senior planner, wealth management, CWB Wealth in Calgary, says employees need to work with their advisors to design a disciplined strategy around their stock options so they fit within their financial plans.
“It’s quite easy to get greedy and to want more from a share price perspective, and … always wanting to be exercising options when they’re hitting the 52-week high,” he says.
“Ultimately, it comes down to having the discipline [and] striking a balance between understanding your financial needs in retirement, where the stock options fit into your overall portfolio from a diversification perspective, and the risks you may be carrying into retirement by continuing to hold options.”
For some, exercising their options in a down market means locking in today’s price and taking risk off the table as they have a known share price and tax liability, especially as tax rules around stock options could change again, he adds. That cash can also be redeployed to more diversified or tax-sheltered investments like a registered retirement savings plan or tax-free savings account.
However, the downside of settling that tax liability now is “potentially having fewer dollars working for you” as well as “losing that stronger potential upside,” he says.
Factors that also could affect the timing of exercising stock options include if the employee plans to leave the company, feels they may get laid off, is ill, or is close to retirement, Mr. Fennessy explains. There is also a benefit to hold on to stock options until clients are retired and in a lower tax bracket.
“It’s having that balanced perspective of not necessarily allowing the tax implications to really steer the direction, but [make decisions] more so from a needs-based analysis,” he says.
For more from Globe Advisor, visit our homepage.