Stock options are an increasingly popular form of employee compensation. They come in two flavors, which are treated differently for tax purposes: non-qualified stock options and incentive stock options. Non-qualified stock options are the more common of the two. Here’s what you need to know if they’re are part of your compensation package.
An Introduction to Stock Options
Stock options allow employees to buy their company’s stock at a predetermined price within a certain time frame, then potentially see a profit if the price rises. If, for instance, you’re given the right to buy shares of company stock for $20 per share, and four years later the price has risen to $100 per share, your stock options allow you to purchase the stock at the original $20 price. At this point, you can either sell the stock (for a big profit!) or hold onto it in hopes that it will go even higher.
If you’re offered a non-qualified stock option plan, you’ll get a document outlining all the rules. Here’s some of the lingo you may encounter.
- Issue Date: The date when your employer provided you with the stock options
- Market Price: Current price of the company stock
- Grant Price: The set price at which your employer will allow you to buy the company stock at. This is typically the market price of the stock at the issue date. You might also see the grant price referred to as the exercise price or strike price.
- Vesting Schedule: The period of time over which you’re granted the right to buy the company stock at the grant price
- Cliff: The date on which you can first exercise your right to buy your stock options
- Exercise Date: The date when you purchased company stock at the grant price
- Expiration Date: The date at which you no can no longer exercise your options if you haven’t already.
As a general rule, if your options have vested, and the current stock price is above the grant price, you should exercise them. It’s effectively an arbitrage opportunity: You have the ability to buy an asset at a price lower than its market value. This is especially true if your options are about to expire.
However, non-qualified stock options carry some important tax implications that you need to understand before exercising. While it’s best to consult a financial advisor to understand these tax issues, here’s a primer on how non-qualified stock options are taxed.
How Are My Options Taxed?
With non-qualified stock options, you trigger a tax bill the moment you exercise your options. Specifically, you’ll owe tax on the “compensation element”. This is the difference between the grant price and the market price of the stock when you exercised your options. In other words, the gain you realize by buying shares below their market price is treated as compensation.
As an example, let’s say your plan allows you to buy shares of company stock at a grant price of $25 per share. The market price of the stock rises to $45, and some of your stock options have already vested, so you decide to purchase 100 shares at $25 each.
You’ve spent $2,500 (100 shares, at the original $25 strike price), and receive stock worth $4,500 (those same 100 shares, at their current $45 value). The $2,000 difference – the money you made by exercising your stock options – is the compensation element. The company reports it to the IRS and it’s treated the same as any other income, subject to income, Medicare, and Social Security taxes. If that compensation element is large enough, it may push you into a higher tax bracket for the year.
This isn’t the end of the tax story, however. Once you’ve exercised the stock options, you might choose to sell them. As with any other stocks, the profit you realize from this sale is considered a capital gain. If you sell within a year, your profit will be subject to the ordinary income tax rate. However, if you can wait at least a year before selling, it will be taxed at the long-term capital gains rate, which is lower.
When to Sell Your Stocks
Once you’ve exercised your options and bought the stock, the next big decision is when to sell. A few factors may affect that decision.
Whether You Can Afford to Exercise
In some cases, you might have no choice but to sell at least some of your stock. This would be the case if you don’t have the cash on hand to exercise your options. In this case, you can arrange an “exercise-and-sell-to-cover” transaction. In this transaction, the brokerage handling the purchase effectively fronts you the money to exercise the option. Then, you immediately sell enough of the stock to cover the purchase.
Holding your stocks for at least a year before selling will allow the gain to be taxed at the long-term capital gains rate. Of course, if you suspect the stock will significantly drop in value over the next year, the incremental advantage in tax treatment may not be worth the risk of waiting to sell.
This brings up another factor: Your company’s performance. If your company takes a huge plunge before you exercise and sell, you’d miss out on an opportunity to make a profit. Consider, then, how you think the company stock will perform going forward. And while you’re at it, think beyond the company itself. Look at what’s going on with your competitors, your sector in general and even the stock market as a whole.
Current Financial Situation
The decision to sell or hold is also contingent on your own financial needs and goals. If you have a lot of high-interest-rate debt, selling your stock would give you cash to make a dent in that debt. You might also have other financial needs that require an influx of cash, such as a big medical bill or a down payment on a mortgage.
You might also decide that holding too much of your portfolio in one company is too risky – even if that company is your own. If so, it might make sense to diversify by selling at least some of your stock and putting it towards other securities or asset classes. You can use our asset allocation calculator to decide what your asset allocation should look like.
Non-qualified stock option plans have the potential to net you a nice profit if your company succeeds. However, taxes will take a bite of your gains when you exercise, and again when you sell. Before exercising and selling, consider the company’s prospects, the tax implications and your own financial situation.
Tips on Investing
- Want to see how exercising your stock options will impact your taxes? Our tax calculator may be able to help. And if you’re thinking of selling your stock, be sure to check out our capital gains tax calculator.
- Given the complicated tax and financial implications of stock options, it may be wise to work with a financial advisor. Use our SmartAsset financial advisor matching tool to get matched with up to three financial advisors in your area.
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