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Preparing for the year-end bounty

Tanvi Varma/Money Today        Print Edition: April 2011

Is your employer planning to grant you Employee Stock Options (Esops) this year, along with your regular bonus, increment or promotion? What can you do with this windfall? This is a good time to understand this complex system that some companies have chosen to reward employees. In case you are a beneficiary, you must have a financial plan in place to invest this bonanza.

DECONSTRUCTING ESOPS

The trend of awarding Esops was started by the information technology (IT) industry. "Many sectors today, including financial services, retail and consumer products companies, are extending this benefit," says Homi Mistry, partner, Deloitte Haskins & Sells. But why Esops? "This is primarily an employee retention tool," says Anil Rego, CEO, Right Horizons. It is important to understand the nitty-gritty as unlike a bonus, the tax treatment for Esops is complicated.

It is only after the vesting period-decided by your employer-that you can exercise your option to buy the shares of the company you work for, at a pre-determined price. This price is generally lower than the prevailing market rate. "In fact, these are structured in such a way that the exercise is staggered over three to five years. The idea is to ensure that the employee is tied with the company for the long haul," says Rego. An employee typically buys the shares only if the market price is higher than the exercise price.

Tax on Esops is paid on the difference between the fair market value (FMV) of the stock (the average of the opening price and the closing price on the day the option is exercised) and the price at which the option was granted. "This amount is treated as a perquisite and taxed in the hands of the employee," says Mistry (See Taxing Times). You also pay 15% short-term capital gains tax if you sell these shares within one year from the date of allotment. There is, of course, no long-term capital gains tax, as in the case of other equity transactions.

"Typically, Esops over the long haul could prove to be a sure way of enhancing your net worth," says Rego. But financial planners say the tax liability can be an undue drain on finances, especially if the amount is large. For instance, if the number of shares as mentioned in Taxing Times was 1,000 instead of 10, the tax liability could have crossed Rs 1.5 lakh.

"Many times, this results in employees selling off their shares immediately to ensure that the adequate tax amount is available," says Mistry. However, you still have the option of selling a few shares and holding on to the rest.

DEPLOYMENT AVENUES

The cash that your stock options bring in could be a big lumpsum. The temptation to spend it all will be extremely hard to resist. But here is a word of caution. "Depending on the quantum of your windfall, you should try to invest at least 40% of the amount," says Kartik Jhaveri, certified financial planner with Transcend Consulting.

Alternatively, if your contingency fund is running low, this may be a good time to replenish it. According to financial experts, at any given point, you should put aside an amount equal to about 6 months of your expenses, for such a fund. You can either park this money in a bank fixed deposit or a short-term fixed maturity plan (FMP), since both offer short-term maturity options. Earlier, a liquid fund would have been ideal, but in the current interest rate environment these funds fetch very low returns of about 4.5-5%.

Jhaveri suggests that the money can be used to fulfill any deployment which may be pending as per your financial plan. For instance, if you need to increase your equity allocation, this lumpsum can be converted into a Systematic Transfer Plan (STP), whereby money is transferred into an equity fund at the frequency you choose. This works like a Systematic Investment Plan (SIP) and lowers the risk of investing all your funds in stocks at one go.

Also, it may be worthwhile to prepay any expensive loans that you might be carrying. This could include your credit card outstanding that comes at an interest rate of up to 36% or your personal loan on which you might be paying between 18% and 20%. You could also consider prepaying your home loan. If you have a good deal on interest rates and are saving tax through the loan, this may be given a miss.

You may want to consider investing some of your windfall into an alternate asset class," suggests Rego. It could be a direct equity portfolio or a commodity fund. So, there are a number of options to choose from. Just wait for the good news to trickle in.

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