Some employers allow employees to purchase company stock either through a 401(k) plan or stock options. These incentives are provided as employee benefits that can be used for retirement or as a bonus.
Over time, your employer’s stock can add up to a considerable percentage of your portfolio. And that’s risky. If something goes wrong with your company you could be both out of a job and out of a sizable chunk of your nest egg.
So you wonder: Should I invest in my employer’s stock or not?
Sure, as long as you ensure your portfolio remains diversified and you don’t get emotionally attached to your employer’s stock.
Your employer’s stock in a 401(k)
In a typical 401(k) plan, you will have the option of delegating a percentage of your contributions to a number of mutual funds offered through the plan. Some companies may include their own stock as one of the choices available, allowing you to personally invest in the company you work for and share in any profits.
It’s a great incentive, but easily mismanaged.
A good rule of thumb for diversification is to never invest more than 10 percent of your money into any single stock holding. It’s okay to invest in your company, but history has taught us that relying on any one source of income can lead to disastrous results.
Remember Enron in 2001? They encouraged workers to invest in the company stock to the tune of $1.2 billion – all of which became worthless. Thousands lost their jobs and their life savings because they had everything tied up into one single company. It’s a sobering lesson in improper diversification.
Employee stock options
An employee stock option (ESO) is a rather complex call option on your employer’s stock. Employers may grant stock options to employees as part of a compensation package because, in theory, this encourages the employee to contribute to the company’s success and a rising stock price.
An ESO gives the employee the option to buy company stock (exercise the option) once the stock price reaches a certain price (the call price). If an employee exercises the options, he or she pays the options’ exercise price and is issued shares of stock at the current market price. The employee immediately profits the difference between the options’ exercise price and the market price.
If the stock’s price never rises above the exercise price or the employee simply chooses not to exercise the options, they will eventually expire.
Stock options generally come in two forms made distinct by their tax status:
- incentive stock options
- and non-qualified stock options.
Incentive stock options are the tax-favored form that benefit employees by allowing them to avoid ordinary income taxes on the difference between the exercise price and the fair market value of the stock issued. Instead, if shares are held for a year after exercise and two years from the date of the grant, they may only be subjected to capital gains tax.
Non-qualified stock options are taxed as ordinary income and have no preferential tax treatment. (Note: Unless you are in upper management, this will be the form you will most likely see.)
A word of caution for those of you who may be considering exercising your stock options. Even if you hold on to the stock after exercising the option, you will still be liable for taxes. This could be a major headache if you exercise a considerable amount and decide to hold on to the stock instead of just dumping it come tax time.
The wisest course of action is to hold the options until right before they are about to expire so that you don’t incur a tax liability for which you aren’t prepared. Keep in mind, some employers may also allow you to give stock options to your children or even donate them to charity.
Employer stock can be valuable, if handled right
When it comes to getting preferential price treatment as an employee, The National Center for Employee Ownership estimates that you generally receive an amount equal to between 12 and 20 percent of your salary from the “spread” between what you pay for the option stock and what you sell it for. Most options are good for 10 years as well, so there’s no rush to sell and figure out how to handle the tax situation as a result.
Working for an employer that offers stock options either outright or through a 401(k) plan isn’t as rare as you think. The National Center for Employee Ownership estimates that over 9 million Americans currently hold stock options in amounts in excess of $200 billion dollars.
If you have them at your workplace, check to see if it’s available through your 401(k), in which case you’ll need to make sure you stay diversified, or if they are options. If they are options, verify if they are incentive or non-qualified and talk to a tax professional before exercising them to avoid any messy situations.
What about you? Have you invested in your employer’s stock? How does that investment fit into your overall financial plan?
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