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Lesson 7. When to Exercise Your Options > What Are Your Options? - Pg. 34

When to Exercise Your Options 34 Exercise the Options and Hold the Stock You may find that exercising your options and holding onto the stock for some period makes more sense than the other alternatives. Here are some good reasons to exercise your options and hold onto the stock: · You want to add the stock to your portfolio. --Buying stock at a discount through stock options is a great way to build a strong financial future. Discounted stock has a profit at the outset and that makes your return even better. You choose this course of action because you believe the company will continue to grow. A bad investment bought at a discount is most likely still a bad investment. Tip If you have neither the time nor the interest to follow individual stocks, consider cashing in your options and investing the money in a good mutual fund. · You own incentive stock options. --ISOs create no tax liability until you sell the stock, assuming you meet all the requirements. When you do sell, the profit is a long-term capital gain, which is often lower than ordinary income tax rates. · You own nonstatutory stock options. --You must pay ordinary income tax on the spread between the grant price and the fair market price of the stock on the day you exercise your options. Once that burden is behind you, there are no more tax liabilities until you sell the stock. If you hold the stock for more than one year, it qualifies for long-term capital gain tax. If you believe the stock is going to continue to grow, it may make sense to pay ordinary income tax on the spread when it is small rather than waiting years, then facing a large ordinary tax liability when you exercise in the future. Caution Dividends are an exception to the no-taxes-until-you-sell rule. Some companies pay divi- dends to their shareholders. Whether you take the dividends in cash or reinvest them, you still owe ordinary income tax on them each year. · You want to use the stock as a gift. --Many employee stock option agreements limit or prohibit transferring the option under most circumstances. ISO holders can't transfer their options under any circumstances, according to the tax code. Even if your option agreement does permit trans- ferring (giving) your options, there are serious tax and estate planning consequences. One way to avoid these problems is to exercise your options and give the stock away. There are still some tax and estate considerations, but they are less severe than transferring options. Here are some good reasons you shouldn't exercise your options and hold the stock: · You don't have the cash. --You will need the money to pay for the stock when you exercise your options. Some employers may provide financing for stock purchases or make other arrange- ments to help you. If not, you will need to come up with the cash. I talk about ways to pay for the stock in Lesson 8, "Exercising Your Options." · You already own a lot of the stock. --You shouldn't own too much of one stock in your portfolio for the reasons I discussed eariler. · You believe the company is declining. --Obviously, if you believe the company's stock is going to drop, you don't want to own it. Holding stock for future appreciation is an excellent way to build wealth as long as you have confi- dence in the company's future.