Understanding Employee Stock Option Plans

The boom days of the 1990s may be over, but stock option programs continue to be popular with public and private companies. Employees certainly can benefit from them, if they take some time to learn the basics.

Got stock options from your employer? Be sure to know the rules before exercising.

In the dot-com boom years of the 1990s and early 2000s, many companies made liberal use of employee stock option plans (ESOPs) to both reward and retain valued staff, from executives to temporary administrative help. While the current economic climate has produced fewer "company stock millionaires" these days, stock option programs continue to be popular with public and private companies. And employees certainly can benefit from them, if they take some time to learn the basics.

 What Is a Stock Option?

If you've been granted stock options, you've been given the right to purchase shares of your company's stock at a certain price under certain conditions set by company management.

•          If you have immediate options, you can purchase your alloted shares at any time.

•          If your options are vested, you can only purchase a set number of shares after you've worked at the company a certain period of time.

•          If your options are performance-based, they will vest once certain goals are met.

The two most common types of ESOPs are incentive stock option (ISO) and nonqualified stock option (NSO) plans. Usually, key executives are granted ISOs, while less senior employees are given NSOs. The chief difference between the two is tax treatment.

•          An ISO can be taxed under long-term capital gains, assuming the employee holds the stock for at least two years from the option grant date and one year from the exercise date. They are also taxed only when the stock is sold, making them tax-deferred plans. Note that ISOs can trigger the alternative minimum tax (AMT).

•          NSOs are taxed as both income and capital gains -- and the tax is owed once the options are exercised. This is an important consideration to anyone who is thinking of exercising options. If you don't have enough cash on hand to cover the tax bill, you may need to sell shares you've just purchased to cover the costs.

Exercising Options

Most stock options have an exercise period of 10 years; that is, you have 10 years from the time you receive the options to actually purchase the stock. You are not obligated to buy any shares, particularly if your company's stock price is trading below your set exercise price. If you don't make a purchase during the exercise period, your options will expire worthless.

Companies have the flexibility to exchange option grants if its stock has been negatively affected by market activity. For example, if your stock options are priced at $25 a share and your company stock has been trading at only $20 a share for a prolonged period, the company may exchange your $25 strike price options for a new set that gives you a lower strike price.

If you are participating in an ESOP, be sure to consult with a financial and/or tax professional who can help you decide when to exercise your shares and how to deal with the tax consequences.

© 2011 McGraw-Hill Financial Communications. All rights reserved.

November 2011 — This column is provided through the Financial Planning Association, the membership organization for the financial planning community, and is brought to you by Jim Ellman ChFC and Barry Mendelson, CFP local members of the FPA.

Estate Planning with Roth IRAs

As Roth usage increases, so do questions about best estate-planning practices for these accounts.

Natalie Choate, 11/11/2011

Since the "income cap" was lifted on Roth conversions in 2010, more and more clients have Roth IRAs. It's time to consider where those assets should be placed in the estate plan.

Question: I read in a financial publication that giving away a Roth IRA is "a good planning idea." Several other articles are out there about this strategy. Does it really work?
Answer: No. You cannot give away a Roth IRA. Or rather, you can do so, but giving it away would cause it to cease to be an IRA. The gift-transfer would be treated as a complete distribution of the account to the donor, followed by a gift of the proceeds to the transferee. The deemed distribution might be tax-free (if the donor meets the requirements for a "qualified distribution"), but there will be no further tax-free accumulation because the Roth ceases to exist.

A "Roth gift" strategy that does work is for a donor (typically the parent of a teenager) to open a Roth IRA for the donee (the teenager). Example: Teenager earns $5,000 in a summer job. Teenager therefore has compensation income, and if his income is low enough, he is entitled to contribute to a Roth IRA. The parent and teen can open the account together in the teen's name and the parent contributes $5,000 to it.
Both of these strategies are discussed in ¶ 5.8.06(C), "Gifts with Roth IRAs," of my book Life and Death Planning for Retirement Benefits (7th ed. 2011).

Question: "Duncan" wants to leave some of his assets to charity, some to his wife, and some to his children. He has some assets in a traditional retirement plan, some in a Roth plan, and some in outside (nonretirement) investments. Which asset should he leave to which beneficiary?

Answer: With a traditional IRA, all three of Duncan's proposed beneficiaries are considered "tax-favored" choices for income tax purposes: Children (or other young people) because of their long life expectancies (facilitating a long tax-deferred "stretch" payout), the spouse (because she can roll over to her own IRA), and charity because it is income tax-exempt. In Duncan's case, leaving the traditional plan to charity is very appealing, since the charity (unlike the wife and children) can receive these retirement plan benefits income tax-free.

With the Roth plan, the picture changes slightly. Charity is not an income tax-favored choice of beneficiary for a Roth plan. Because distributions from a Roth plan are generally income tax-free anyway, there is no advantage to leaving this asset to an income tax-exempt entity. Thus, Duncan should leave the Roth plan either to his spouse or to the children.

If federal estate taxes are a concern, there is a strong argument against making the traditional IRA payable to the children. By inheriting the traditional IRA, they would be inheriting an asset that has a built-in income tax "debt." Duncan does not get a marital or charitable deduction for leaving assets to his children; the only estate tax "shelter" there is for bequests to his children is the federal estate tax exemption. Part of that exemption is "wasted" if the children inherit an asset that they then have to pay income tax on--part of the "exempt" amount goes to the IRS. So the children should inherit either the Roth plan or the nonretirement assets; either way, they will owe no income tax on their inheritance.

We have figured out that the charity should inherit the traditional retirement, and the children should not inherit it; that leaves the Roth plan and the nonretirement assets to be divided somehow between the spouse and the children. The question is, what is the best income tax scenario for the Roth plan?
If a Roth IRA is left to the children, they can stretch it out via annual tax-free distributions over their life expectancies. That's a pretty darn good scenario.

But if the Roth plan is left to the surviving spouse, she can get an even better scenario: She can roll the inherited Roth plan over to her own Roth IRA (only the surviving spouse has this right). Then she will be able to stretch out the tax-free distributions much longer than the children possibly could: She does not have to take any minimum required distributions at all from the rollover Roth IRA during her lifetime. After her death it can be left to the children for gradual tax-free distributions over their life expectancy.

Duncan's choice is made: Leave the traditional retirement plan to the income tax-exempt charity, the Roth plan to the wife for her to roll over and keep accumulating tax-free, and the nonretirement assets to the children.

Resources: For all details regarding Roth retirement plans, including who is eligible to contribute (and how much), income tax treatment of Roth distributions, and minimum distribution requirements for Roths, see Chapter 5 of Natalie Choate's book Life and Death Planning for Retirement Benefits (7th ed. 2011).

The views expressed are the author’s.

The Pros and Cons of Health Savings Accounts

As health care costs continue to rise, consumers must find ways to ensure that they have the funds to pay for medical expenses not covered through their insurance. One way to save specifically for health care costs is to fund a health savings account, or HSA.

HSAs are tax-advantaged savings accounts set up in conjunction with high-deductible health insurance policies. Enrollees or their employers make tax-free contributions to an HSA and typically use the funds to pay for qualified medical care until they reach their policy's deductible.

HSAs are not for everyone, and it is important to understand how they work before considering them to help fund health care costs.

Understanding HSAs

You are eligible for an HSA if you meet all four of the following qualifying criteria:

1.       You are enrolled in a qualified high-deductible health insurance plan (known as a "HDHP").

2.       You are not covered by another health plan (whether insurance or an uninsured health plan).

3.       You are not eligible for Medicare benefits.

4.       You are not a dependent of another person for tax purposes.

HSAs are generally available through insurance companies that offer HDHPs. Many employer-sponsored health care plans also offer HSA options. Although most major insurance companies and large employers now offer an HSA option under their health plan, it's important to remember that most health insurance policies are not considered HSA-qualified HDHPs, so you should check with your insurance company or employer to see how an HSA plan might differ from your current plan.

The maximum contribution to an HSA for 2011 is $3,050 for single coverage or $6,150 for family coverage. If you are over age 55 then you can contribute an additional $1,000 regardless of whether you have single or family coverage. Contributions are made on a before-tax basis, meaning they reduce your taxable income. Note that unlike IRAs and certain other tax-deferred investment vehicles, no income limits apply to HSAs.

HSAs offer investment options that differ from plan to plan, depending upon the provider, and allow users to carry account balances over from year to year. Earnings on HSAs are not subject to income taxes.

Any medical, dental, or ordinary health care expense that would qualify as a tax-deductible item under IRS rules can be covered by an HSA. A doctor's bill, dental procedure, and most prescriptions are examples of covered items. See IRS Publication 502 for a definitive guide of covered costs. If funds are withdrawn for any purposes other than qualifying health care expenses, you will be required to pay taxes on amounts withdrawn plus a 10% penalty.

Here are some pros and cons of this product.

Pros

•          HSAs offer a significant annual tax deduction (up to $7,150 in 2011 for an individual over 55 who opts for family coverage), making them particularly appealing to individuals in higher tax brackets.

•          Withdrawals for qualifying health care costs (including long-term care insurance) are tax free.

•          Investment income in HSAs is also tax free.

Cons

•          Since HSAs must be tied to HDHPs, their ultimate savings must be weighed against how such plans stack up against more traditional plans, which may offer significantly better coverage.

•          HSAs may not offer the flexibility and transportability that today's mobile American family requires, especially given that health plan offerings differ significantly from employer to employer and many smaller institutions have yet to offer an HSA option.

© 2011 McGraw-Hill Financial Communications. All rights reserved.
October 2011 — This column is provided through the Financial Planning Association, the membership organization for the financial planning community, and is brought to you by   James P Ellman, ChFC and Barry Mendelson, CFP,  local members of FPA.