Get the Most Out of Employee Stock Options

Getting the most out of employee stock options means in part using them to your advantage come tax time. Over the years, employee stock options have become increasingly common to recruit higher-ranking employees and give them a sense of ownership in a company. According to the National Center for Employee Ownership, approximately 6,500 employee stock ownership plans cover 14 million participants.

Indeed, stock options, which give you the right to buy shares at a pre-determined price at a future date, can be a valuable component of your overall compensation package. But to get the most out of them, it’s essential to understand how they work and how they’re treated for tax purposes.

How Employee Stock Options Work

Stock options are often offered as an employee benefit. The major advantage of a stock option is the ability to buy shares in the future at a fixed price, even if the market value is higher than that amount when you make your purchase. Your ability to exercise your options is determined by a vesting schedule, which lists the number of shares an employee can purchase on specific dates.

For example, an employer may grant you 1,000 shares on the grant date, with 250 shares vesting one year later. That means you have the right to exercise 250 of the 1,000 shares initially granted. The year after, another 250 shares are vested, and so on. The vesting schedule also includes an expiration date. That's when the employee no longer has the right to purchase company stock under the terms of the agreement.

The price at which the employee can purchase shares is known as the exercise price. In most cases, it's simply the stock's market value on the grant date.

NSO vs. ISO

There are two main types of employee stock options—non-qualified stock options (NSOs) and incentive stock options (ISOs). One difference between them is eligibility. Companies can grant the former to employees, consultants, and advisors. However, only employees can receive ISOs. But the biggest distinction is how they’re treated for tax purposes at the exercise date.

Non-qualified stock options (NSOs)

In the case of an NSO, you incur a bill right when you exercise the option. The difference between the exercise price and the fair market value of the shares is subject to ordinary income taxes in that year.

Let’s say you have options with an exercise price of $10 a share that rose to $30 by the time you exercised them. You’d pay income taxes on $20 per share.

Any further increase in the sale price is subject to the more favorable capital gains rate. which is typically no more than 15% for individuals, when you subsequently sell the shares. Suppose they rose in value to $55 a share when you sold them two years later. You’d pay the long-term capital gains rate on $25 per share (though you’d pay the higher short-term rate if you sold them within a year of their purchase).

Incentive stock options (ISOs)

ISOs are usually seen as more advantageous for the employee because the exercise date isn’t a taxable event. Even though higher-earning employees have to make an alternative minimum tax (AMT) adjustment based on the difference between the current market price and the exercise price.

Instead, you settle up with the IRS when you actually sell your shares down the road. If you’ve held the stock for more than a year, you’ll incur the long-term capital gains tax on the difference between the exercise price and the eventual sale price. So if we use the same prices in the earlier example, you’d pay the capital gains tax of $45 per share ($55 sale price minus the $10 exercise price).

To get the preferred tax treatment, ISOs must be held for two years from the date they are granted and at least one year from the exercise date. Otherwise, a “disqualifying disposition” occurs, and the difference between the grant price and market value on the exercise date is subject to ordinary income tax.

Mind the Expiration Date

Stock options don’t last forever. Typically, there’s a vesting schedule that lasts anywhere from one to four years, though some employees may have up to 10 years. And if you leave the company for whatever reason, whether it’s because of a layoff, resignation, or retirement, you may only have 90 days to use them.

If you have in-the-money options at your disposal, you should act well before the expiration date. Some employees forget about the deadline or wait on their decisions as long as possible, hoping that the price will go up higher still. That strategy can backfire, however.

Special Considerations

A generous stock option benefit is certainly nothing to complain about. But it does have a significant risk—the possibility that too much of your wealth will be tied up in a single stock.

As a general rule, you want to avoid having more than 10% to 15% of your portfolio tied to a specific company. Should the organization fall on hard times, you would not be diversified enough to cushion the blow.

If you’re crossing that threshold, you might think about selling enough stock each year to keep your nest egg safe from excess volatility risk. To account for fluctuations in the market, consider dividing the sale into a series of transactions over a few weeks or months, especially for larger amounts. You can then use that income to increase your 401(k) and IRA contributions.

The Bottom Line

Employee stock options can be a valuable part of your compensation package, especially if you work for a company whose stock has been soaring of late. In order to take full advantage, make sure you exercise your rights before they expire. When you retire, stock options can be highly beneficial, so make sure to take advantage of this benefit if offered to you, but make sure you understand the tax effect of your decisions.