Stock options have become an increasingly popular form of employee compensation in recent years. They provide employees with the ability to buy shares of their company at a predetermined price at some point in the future. Stock options tie compensation to the success of the company, which encourages employees to think like an owner and work to increase profits. To fully understand all your choices when it comes to options speak with a financial advisor.
What Is a Stock Option?
Stock options are a form of long-term compensation for employees. Employees are typically granted stock options based on their rank within and tenure at the company.
As the company’s stock price increases in value, stock options become even more valuable. When they are sold, the employee’s profits are the difference in the current stock price and the strike price. The strike price is the price at which the stock options were issued.
For example, if an employee received 100 stock options at $5, the strike price is $5. Another name for strike price is the grant price. After the options vest, the employee is free to sell them in part or in whole. If the options were sold when the stock price was $20, then the employee would have a profit of $15 per share. These profits are counted as income and must be included in the employee’s tax returns.
Many companies implement a vesting schedule where the options are earned over time. An employee who receives 100 stock options may receive 25 at the end of each year for the next four years. If the employee leaves the company before the options fully vest, they will forfeit any of the unvested options.
How Do You Exercise a Stock Option?
When you exercise stock options, you convert your options into actual shares of the company. You can keep the shares as part of your investment portfolio or you can choose to sell them. Some people keep some shares and sell the others.
Your stock options will have a vesting date. Again, they can vest all at once or over a period of time. Once you are past the vesting date, you can choose when to exercise your options based on the stock price, tax deadlines or any other reason.
To exercise your stock options, you must contact your company’s stock option manager. For most companies, you will have a stock option portal to log into and manage your stock options. In this portal, you can see each of your stock option grants, the strike price, vesting schedule and how many shares are vested versus unvested.
Stock Option Exercise Methods
When logging into your stock option portal, you should have four options to choose from with your 100 stock options:
- Exercise-and-hold transaction. Purchase your shares of stock by paying cash for the option cost, brokerage commissions and any fees and taxes owed. You now own all 100 shares. This strategy is best for investors who are bullish on the company’s future and have cash to cover the costs.
- Exercise-and-sell-to-cover transaction. Sell enough shares to cover the option cost, commissions, taxes and fees. You will own fewer than 100 shares and may receive a residual amount in cash. This strategy is ideal for investors who are bullish on the company, but who do not want to use their cash to complete the transaction.
- Exercise-and-sell transaction. All shares are sold and the investor receives cash after paying all costs. You will receive zero shares from this transaction. Investors use this strategy when they feel the stock is overvalued or when they want to diversify their holdings.
- Hold your stock options. Wait to exercise until the stock options increase in value. This is best for options that are less than the strike price (“underwater”) or when the expiration date is many years away.
For Employees Leaving the Company
Many companies provide a post-termination exercise (PTE) period so that you do not lose your options when your employment ends. This process allows retired, laid off or terminated employees time to exercise their options within a specified timeframe. These former employees can exercise their stock options in the same manner as a current employee.
The PTE period varies from company to company. Some companies offer just three months, while more generous companies allow up to seven years or for as long as you worked at the company.
Only vested options are eligible to be exercised during this period. Any unvested options are forfeited.
How Does This Affect Your Taxes?
Stock options are taxed as ordinary income when they are exercised. Your taxable income is based on the difference between the market price and the strike price. If you sell the shares at a later date, any profits will be taxed as either short- or long-term capital gains, depending upon how long you held the shares.
You will receive a Form 3921 from your employer that provides details of exercising the options. This information is used to complete Schedule D on your federal tax returns.
Exercising stock options may also trigger an adjustment for alternative minimum tax (AMT). Consult with your tax advisor to understand if this situation applies to you.
The $100,000 Rule rule limits how much employees can claim as incentive stock options (ISOs) in one year. ISOs receive favorable tax treatment, so the IRS places limits to prevent abuse of this tax benefit.
Any amount above $100,000 is treated as non-qualified stock options (NSOs) by the IRS. NSOs are taxed both when an employee exercises the stock option and when they sell the stock received.
The Bottom Line
Stock options can be a lucrative form of compensation for employees. The potential for high payouts can “handcuff” an employee to the company and prevent them from leaving to a competitor. When stock options become vested, employees have four choices on how to proceed. After an option is exercised, taxes are owed on the difference between the current market price and the price they were granted at.
Tips on Investing
- After you’ve exercised your options, the shares are yours to hold or sell. Our capital gains calculator will help you determine how much you may owe in taxes when you sell your shares.
- Working with a financial advisor can help you as you consider what to do with your options. Finding an advisor doesn’t have to be hard. SmartAsset’s matching tool can connect you in just minutes with several in your area. If you’re ready, get started now.
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