You may have stock option grants available through your job. Employers offer them as a benefit to you and as motivation to be successful with the employer - creating a potential win win. Whether your at a pre-IPO start-up, a growing public company, or a blue chipper developing a life-saving vaccine - stock options can boost your wealth, now and in the future.
The idea of stock options are pretty straightforward, but the devil is in the details. Maximizing profit is one side of the equation – and dealing with taxes is the other (and the rules can get complicated). This short read can help you sort it out.
Know the Basics
When you receive stock options, the company does not hand you shares of stock right away. Instead, you receive the right to purchase shares of company stock at a certain price (the strike price), usually below market value. Hopefully, the shares’ price will rise over time, so you can sell them at a higher price than when you exercised the options.
When you exercise your stock options, you can purchase shares of your employer’s common stock at the strike price in your option grant. The "spread" is the difference in value between the strike price and the shares' market value when you exercise. While you can exercise your options, you're not required to.
Before you can exercise the options or purchase the shares, the stock must first vest. This usually happens after you have worked for the company for a certain amount of time. Some companies allow you to exercise your options early, before they vest. That can have tax advantages, but you may not be allowed to sell shares of your stock to purchase the vested shares, so you’ll have to shell out your own money.
Stock options are usually either non-qualified stock options (NSOs) or incentive stock options (ISOs). ISOs can provide better tax benefits if you hold on to the stock for a certain period. But, ISOs can trigger the maddening alternative minimum tax (AMT).
Key Questions:
How do I exercise my stock options?
Exercising stock options means buying shares of your employer’s common stock at the price specified in your option grant (strike price). Your company probably has an agreement with a brokerage firm to execute these stock purchases. Once you own actual shares, you do not have to sell them immediately.
How much time do I have?
If your company does not offer early exercising, you can only exercise options once they are vested, which varies from company to company.
What should I consider when deciding whether to exercise?
Are the options in-the-money or underwater? If they're underwater (trading below your exercise/strike price), you probably want to wait for the stock price to rise.
Is your company private and not planning to file for an IPO soon? Then exercising your options may be risky because you are purchasing shares that may not become liquid. You still need to come up with the cash to purchase the illiquid shares.
Will you have to pay taxes? Depending on your situation (what kind of options, number you were granted, and your compensation, etc.), you may have to pay taxes when you exercise.
When should I sell my shares?
After exercising your options, its smart to get professional advice on the most tax efficient path to take when selling the stocks. The type of options you have and your holding period after exercising will greatly impact your tax liability.
Non-Qualified Stock Options (NSOs)
NSOs (not as favorable tax treatment) are the most common type. Most companies typically choose to hand out non-qualified stock options to employees for tax reasons: they can deduct the costs of NSOs as an operating expense sooner than with other options. Unexercised NSOs can be passed on to others, i.e., in divorce or as gifts.
If there's a profit when you exercise your shares (i.e., your strike price is lower than current market price), it will be taxed as ordinary income and reported on your W2 for the year you exercised the options.
Once you receive the shares, you can either sell them or hold them. At this point, anymore tax depends on how long you hold the shares, and if you have additional gain from when you exercised.
Incentive Stock Options (ISOs)
ISOs can have more favorable tax treatment than NSOs, but a schedule needs to be followed. You’ll need to hold the shares for a minimum of two years from the grant date and one year from the exercise date to qualify for long-term capital gains. If your company is pre-IPO, you'll need plan carefully to keep lock-up periods in mind.
ISOs can hit you with the alternative minimum tax (AMT). The AMT is based on the difference between the strike price and the fair market value when you exercise and hold the shares. The bigger the spread, the bigger the AMT. If you pay AMT, you can get this amount back as a credit in the future, but the process is a real pain and you want to avoid it if you can. Because you can choose when to exercise, you might have some flexibility in avoiding or minimizing AMT.
Stock options can bring nice profits, but they require careful planning. Don't try this at home! Contact me to see if I can help.
John Piershale, CFP®, AEP®
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