For many employees in America, especially those at tech companies and other startups, stock options are a part of compensation packages. While the right to buy stock in a company at a set price is an attractive form of compensation, stock options have more complex tax implications than straight cash. Many taxpayers will use a financial advisor to help them develop the best tax strategy for their investments. Let’s take a look at how your tax return will change depending on whether you have incentive stock options (ISOs) or non-qualified stock options (NQSOs).
Types of Stock Options
The two basic types of stock options are non-qualified stock options (NQSOs) and incentive stock options (ISOs). While both are non-traditional forms of compensation, the two types of stock options work differently.
Employees are more likely to receive NQSOs. This option lets you buy shares of your company’s stock at a predetermined price (called a “grant price”) within a specific time frame. If the value of the stock goes up, you have the ability to sell it for a profit.
Incentive stock options are similar to NQSOs but they include a special tax provision, discussed below, which makes them more attractive for employees. Executives or other high-ranking officials at a company are more likely to receive ISOs.
Both NQSOs and ISOs may be subject to a vesting schedule during which you can buy a certain number of shares each year over a period of several years. Regardless of the duration of the vesting schedule, you’ll generally be locked into the grant price you are given when you’re granted the options. This means that even if the value of the company skyrockets, you’ll still be able to buy your shares at the price they were at when you were given the options.
Taxes for Non-Qualified Stock Options
Exercising your non-qualified stock options triggers a tax. Let’s say you got a grant price of $20 per share, but when you exercise your stock option the stock is valued at $30 per share. That means you’ve made $10 per share. So if you have 100 shares, you’ll spend $2,000 but receive a value of $3,000. That $1,000 profit counts as a “compensation element.” Your company will report it to the IRS like it would any other income. It is then subject to all normal income taxes, plus Medicare and Social Security taxes.
Eventually, though, you’ll likely want to sell the stocks and get the money from the sale. Any profit counts as a capital gain. Stocks sold within a year are subject to income tax. If you wait at least a year, they are subject to the lower long-term capital gains rate.
Taxes for Incentive Stock Options
Incentive stock options, on the other hand, are much more tax-friendly for employees. If you receive ISOs as part of your compensation, you won’t have to pay any tax on the difference between the grant price and the price at the time of exercise. You don’t even have to report them as income when you receive the grant or exercise the option.
You will still have to pay tax on the money you make from selling the actual stock units though. The long-term capital gains tax applies to sales made two years after the grant and one year after exercising the option. The regular income tax applies to earlier sales.
Don’t forget about the alternative minimum tax. Those with a lot of tax-free income could be subject to this tax, so it’s important to be mindful of these rules or get the help of a financial advisor.
When to Exercise Stock Options
Here are four times when you may choose to exercise your stock options:
- Changing Jobs: You might exercise your stock options when leaving a company. At that moment, your employer will offer you a post-termination exercise (PTE) period, or a limited timeframe of up to three months to exercise your options.
- Early Exercise: Usually, options vest gradually over a period of time. But some employees can buy company stock right after accepting an option grant. Taking an early exercise means that you can also benefit from paying less taxes on gains. You will need to file tax form 83(b).
- Initial Public Offering (IPO): When company shares are taken public, you can exercise and sell your stock on the market. But keep in mind that if you do not hold on to your stock for at least one year, your gains will be taxed at a higher rate as ordinary income.
- Company Acquisition: If your company gets acquired, your stock options may be compensated or converted into shares of the acquiring company. You might be able to exercise your options during or after the acquisition deal.
How you’ll pay taxes on stock options largely depends on whether you receive NQSOs or ISOs. Either way, you’ll pay income tax or capital gains tax when you sell the shares on the open market. With NQSOs, you’ll also pay income tax on the difference between the share value and your grant price when you actually exercise the option. With ISOs, you won’t have to pay income tax when you exercise the stock option. This makes them more attractive out of the two, but also explains why they’re generally reserved for high-ranking officers in a company.
- Even if you’re not receiving stock options, you may want to work with a financial advisor to optimize your taxes for investments. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors who can help you achieve your financial goals, get started now.
- Knowing how much you’re likely to pay in income taxes is important for planning your financial life. Find out how much you’ll likely owe with SmartAsset’s free income tax calculator.
- There are many different tax planning strategies to lower your taxes. A financial advisor could help you use tax-loss harvesting to bring down your taxes on any capital gains made during the year.
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