How to exercise

There are three basic ways to exercise options: pay cash, swap company stock you already own, and engage in a "cashless exercise."

• Cash. This is the most straightforward route. You give your employer the necessary money and get stock certificates in return. But what if, when it comes time to exercise, you don't have enough cash on hand to buy the option shares and pay any resulting tax?

• Stock swaps. Some employers let you trade company stock you already own to acquire option stock. Say your company stock sells for $50 a share and you have an ISO to buy 5,000 additional shares for $25 each. Instead of paying $125,000 in cash to exercise the option, you could exchange 2,500 shares (with a total market value of $125,000) you already own for the 5,000 new shares. This strategy has the additional benefit of limiting your concentration in company stock (see below). Note: You must have held the swapped ISO shares for the required one- and two-year holding periods to avoid having the exchange treated as a sale and, thus, incurring tax.

• Cashless exercises. This is where you borrow from a stockbroker the money needed to exercise your option and, simultaneously, sell at least enough shares to cover your costs, including taxes and broker's commissions. Any balance is paid to you in cash or stock.

When to exercise

Although conventional wisdom holds that you should sit on your options until they are about to expire to allow the stock to appreciate and, therefore, maximize your gain, many employees can't stand to wait that long. One study found that the typical employee cashed out of his options within six months of becoming eligible to do so, thereby sacrificing an estimated $1 in future value for every $2 realized.

Of course, there are legitimate reasons to exercise early. Among them: You have lost faith in your employer's prospects and, therefore, its stock. You are overdosing on company stock. (It is generally imprudent to keep more than 10% of your portfolio in employer stock.) A quick way to estimate the value of your options is to calculate how much you would pocket after exercising them and immediately selling the shares, ignoring taxes for simplicity.

You want to lock in a low cost basis for your nonqualified options. Since the spread at exercise is taxed as ordinary income, it might make sense to exercise early so you can take most of your earnings in stock appreciation, taxed at lower, capital gains rates.

You also want to avoid getting pushed into a higher tax bracket. Waiting to exercise all your options at once could do just that. Exercising a portion at a time can alleviate this problem.

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