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As employers look to attract key talent, they may offer stock options as a form of compensation. Stock options give employees the right to buy company stock at a stated price within a specific period of time. Employees are usually happy to take the stock options as supplemental compensation, but do they understand what they have been offered? I commonly hear, “Hey, I have options but am not sure what to do with them.” To avoid making common mistakes with your stock options, here are four important T’s to remember:

Type

Two types of options can be issued as employee stock options: incentive stock options (ISOs) and non-statutory stock options (NSOs), also known as non-qualified stock options. To understand your options, you first must know which type you have. As the name implies, incentive stock options offer certain incentives or special tax treatment. Employees are often unaware of which type of option they hold and inadvertently miss tax-management opportunities. Typically, you can find this information through an online portal, grant agreement, or stock option plan document.

Terms

Grant, vesting, exercise, expiration – there are so many terms to remember and understand! Become familiar with each to know when and how you can receive your options. Here is a rundown of some of the more common terms:

  • Grant: When the employer gives the employee an option to purchase a specific amount of shares in company stock at a specific price. The specific stated price is also known as the exercise or strike price.
  • Vesting: The date that shares become available to purchase. Companies can set a schedule for when you can purchase/exercise the number of shares that are granted. For example, a four-year vesting schedule of 1,000 shares could mean: one year from the grant, 25% of the stock vests (250 shares), two years another 25% vests (250 shares) and so on until year four when everything has vested.
  • Exercise: When you purchase company stock. After vesting takes place, you have the right to purchase stock at the stated price until expiration. To exercise means to exercise that right to purchase at the exercise price stated at grant. Congrats, you now own the stock! Note, however, that if the market price of the stock declines below the stated strike price, the option holder will not exercise the shares.
  • Expiration: The time when the grant expires, and you no longer have the option to purchase. Note: Many life events can force the stock option to expire earlier. For example, retirement, death, divorce, corporate mergers, or disability may accelerate the vesting schedule. You should check your plan documents for more details about special circumstances.

Tax

ISOs and NSOs are treated differently from a tax standpoint. You should consult your tax professional on how taxes affect your personal situation, but here are the basics about the differences:

  • NSOs are taxed as compensation at your ordinary income tax rate on the difference between the exercise price and fair market value on the day of exercise, known as the “bargain element.” For example, if you were granted the stock at $10/share and on the day of exercise it was selling for $15/share, you would owe income taxes on $5/share. This is also subject to payroll taxes (Social Security, Medicare, etc.). Exercise gives you ownership of the stock but does not mean you have to sell the stock. Subsequently, any gain/loss in the stock would be taxed at capital gains rates when sold.
  • Unlike NSOs, ISOs are not taxed at exercise. If the employee meets the applicable Internal Revenue Code holding period and other requirements, the taxation on the shares exercised is deferred until the shares are subsequently sold. Not only is the taxation of the ISO deferred, but the taxes incurred will be at preferential long-term capital gains rates, versus the ordinary income tax rates to which NSOs are subject. To meet the requirements for a tax-favored qualifying disposition, you must not sell the shares purchased under the ISO within a year of exercise, or two years from the date of grant (I told you those terms were important!). Otherwise, it would be considered a disqualifying disposition and would be taxed as compensation at ordinary income rates on the bargain element – much like an NSO. Only gains from appreciation after exercise would be taxed at capital gains rates. Adding to ISO tax complexity is the fact that while there is no regular tax impact upon exercise, there may be alternative minimum tax implications.

Tolerance

As the saying goes, “Don’t let the tax tail wag the dog!” In other words, taxes are an important consideration when it comes to stock options, but shouldn’t be your sole consideration. Think of tax as one part of your overall financial plan. It is common for employees to keep their stock options and forget to sell the stock. Investors commonly hold company stock indefinitely and unintentionally create a concentrated stock position without considering their entire plan. Remember to review your risk tolerance, how much you feel you can afford to have in one single stock, and your financial goals.

If it seems like there are many factors to consider when exercising stock options, you’re right! Your financial planner and accountant can help navigate these murky waters. When in doubt, refer to your stock option plan documents, and ask your employer or other financial professionals for help.

Author Teryn A. Fitzgerald Financial Advisor

Teryn has been involved in the financial services industry since 2009. She is a member of Cents of Self, an initiative that inspires, informs, and empowers women to pursue their best financial futures.

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