Don't count stock options before they're hatched

Employee stock options are becoming a popular way to supplement employees' income, but few employees understand how they can be left holding the bag if they leave their jobs.

A stock option is the right to purchase a company's stock now or in the future at an established price.

By tying benefits to stock ownership, the company uses stock options, which gain value as the price of the underlying security appreciates, as a long-term incentive to retain valued employees.

There are two types of options: incentive stock options or nonqualified stock options.

These option types differ mainly in the tax consequences to both the employee and the company granting them.

Although the provisions governing a company's stock options are outlined in plan documents, many employees still don't understand what will happen to their options if they leave their employers.

When a person leaves his job, the employer not the employee decides what happens to the stock options.

When someone leaves a job, whether the person is fired or quits, that individual generally has only 90 days to exercise his vested stock options. After the 90 days, the options no longer can be exercised.

In addition, the employee's options stop vesting on the day he gives notice that he is leaving the job and any unvested stock options are immediately canceled.

Getting laid off. If an employee is laid off, the employer may decide to be more generous with how employee stock options are handled.

For example, the options could continue to vest for one more year or, in some cases, all of the employee's unvested options may immediately be vested.

However, even if the company gives the employee a year to exercise the options, if those options are incentive stock options, those incentive stock options turn into nonqualified stock op-tions in 90 days.

The disadvantage of holding nonqualified stock options is that the spread between the market price on the day the employee exercise the option and the price at which the option was granted is taxed at ordinary income tax rates.

In comparison, the spread on incentive stock options is not immediately taxed (but may be subject to the alternative minimum tax).

Quitting your job. If the employee quits his job, some companies can recapture profits from stock options the employee exercised previously in what is called a "claw back" provision.

Paying back the company profits from previous exercises can be a problem, especially if the employee sold the shares and spent the proceeds.

Retiring early. If an employee has accumulated enough wealth through stock options and other benefits and decides to retire earlier than the company's stated retirement age, the company may classify the employee's retirement as a termination.

If that occurs, the company might cancel all the employee's stock options or require that they be exercised within 90 days or less.

When exercising stock options, employees need to determine if they are interested in holding the shares of stock that they receive from their exercise or want to sell the shares and invest the sale proceeds in other securities.

Unfortunately, some employees choosing to hold the stock mistakenly exercise their options when the market price of the shares is much higher than the exercise price, which increases the employees' tax bill.

If the employee wants to hold the stock, he should exercise the options when the market price is as close as possible to the exercise price to minimize taxes.

Another important fact to keep in mind is that most stock options expire within 10 years and become worthless if the employee hasn't exercised them.

The best defense is for employees to carefully read the stock option documents, understand their provisions and know where the stock options fit into their overall financial picture.

(The preceding article was provided by Timothy M. Reese, vice president of investments with A.G. Edwards & Sons, member SIPC.)