Congratulations if you were recently granted stock options by your employer that are tied to the company’s stock. Options can be a lucrative part of your compensation, and you should look to take advantage of this financial opportunity.
Stock options are issued to employees of companies whose stock is publicly traded as well as to employees of companies that have not yet gone public. In the latter case, it’s a way for key employees to participate in any potential upside in the firm’s stock when the company does go public.
Some private companies also may provide stock as compensation to outside consultants and advisors as a way to reduce their cash outlay for these services and to potentially pique their interest in working with the company.
Here are some things you should know if you are granted employee stock options (ESOs) and how to determine whether it makes sense to exercise them.
How employee stock options work
Employee stock options are granted to specific employees by their companies. These stock options grant employees the right to purchase a number of shares at a fixed price for a specified period of time.
Companies may grant options to enhance the compensation of certain employees and also to provide an incentive for outstanding performance. “If the company does well, then the stock will do well too” might be the thought process of an employee holding options. It ties the financial well-being of these employees at least in part to the financial fortunes of the company.
Here are some key terms to know about ESOs:
- Grant date: The date on which your employer granted you the options. This date is important in that any taxes due later on in the process could be tied to this date.
- Vesting schedule: The schedule under which you eventually become vested in the options. Vesting means that you take full control of the options. The vesting schedule commences with the date the options are granted to you. The schedule will lay out the timetable over which you become eligible to exercise the options, converting the options to shares of the company’s stock. Vesting for the options may occur all at once or over a defined period of time. For example, the options might vest at a rate of 20% per year over a five-year time frame.
- Strike price: Also known as the exercise price or grant price. This is the specified price at which you can purchase the shares by exercising the options. This price generally will be at a higher level than the stock’s price on the grant date. Note, however, that the actual price on the date you are eligible to exercise some or all of the options might be higher or lower than the strike price based on the performance of the stock over time.
- Expiration date: The date by which your options must be exercised; otherwise, they will expire. If the options vest over time, there likely is an expiration date for each lot as they vest. If you allow the options to expire without exercising them, they become worthless.
Types of employee stock options
There are two types of employee stock options: nonqualified stock options and incentive stock options (ISOs). They differ in several ways and should play a role in the exercise strategy you choose.
“The first thing you may want to do is identify whether you have been granted nonqualified stock options or incentive stock options, as the tax implications of an exercise are materially different,” said Daniel Zajac, certified financial planner at Simone Zajac Wealth Management Group, which is based outside Philadelphia. A good portion of Zajac’s practice is devoted to advising clients on stock option-related issues.
Nonqualified stock options
Nonqualified stock options are the simpler of the two types in terms of taxation. “When you exercise nonqualified stock options, any gain will likely be taxed in the year of exercise as ordinary income, subject to payroll tax,” Zajac said.
When you exercise the option, you pay taxes on the difference between the share price at which you exercise the options and the grant price. This gain is taxed as ordinary income, just like your salary and most other types of income you might earn. Besides federal and state income taxes, the income generated by the exercise of the options would be subject to payroll taxes, such as FICA (Social Security) and Medicare, just like any other income earned from employment.
Note that once you exercise the options, if you hold the shares of stock for at least a year, any gain on the sale of those shares would be taxed at lower capital gains rates.
Incentive stock options
ISOs are more challenging from a tax perspective. “The exercise of incentive stock options is materially more complicated, as tax will depend upon how long you’ve owned the option, when you exercised the option and when you sell your shares,” said Zajac. “You may also need to plan for both ordinary income tax, long-term capital gains tax and the alternative minimum tax.”
Unlike with nonqualified options, there are no payroll taxes at the time of exercise, but the exercise of the ISO potentially would count as income for alternative minimum tax purposes.
“The alternative minimum tax, or AMT, is calculated every year along with your regular tax. As a taxpayer, you pay the higher of the two,” Zajac said. “In a calendar year that you exercise and hold incentive stock options, it’s possible that your AMT will be the higher of the two, and you should plan for this potentially large tax bill.”
The good news for many readers is that the tax reform legislation enacted at the end of 2017 raised the income threshold to trigger the AMT, meaning that fewer middle-income taxpayers will be subject to this extra tax.
Under certain circumstances, the sale of the shares after exercise of the options can be subject to the generally preferential capital gains tax rate for federal taxes. If the ISOs are held for at least a year prior to exercise and then the shares are held for at least a year after exercise, any gain on the sale of those shares would be subject to long-term capital gains rates.
The following example illustrates the advantage of paying tax at long-term capital gains rates: For 2019, someone who files their taxes as single hits the marginal 22% tax bracket for ordinary income at an income level of $39,476 and reaches the 24% marginal bracket at an income level of $84,201.
By contrast, the long-term capital gains rates for those filing as single in 2019 are:
- 0% up to an income level of $39,375
- 15% from $39,376 to $434,550 in income
- 20% above $434,551
The differences in rates are similar for taxpayers who are married filing jointly.
Deciding whether to exercise the options
The stock’s market price: The most key consideration when deciding whether to exercise your options probably is where the current market price of the underlying stock is relative to the strike price on the options.
If the strike price of the options is $20 per share, for example, but the current market price of the stock is at $15 per share, you’d be foolish to exercise the options. If you wanted to purchase the stock, it would be more economical to buy it outright using a brokerage account or another method.
If the market price is below the strike price, it likely makes sense to hold the options until such time as the stock rises above the strike price. If the options expire worthless, that is still a better outcome than overpaying for shares of the stock.
Taxes: With most investment and financial decisions, taxes should be a consideration but not the driving force. If the market price of the stock is higher than the exercise price, you can set aside some of your proceeds to cover the taxes.
Additionally, you may need the proceeds from the shares to beef up cash reserves, pay off debt, cover an unexpected major expense, etc. These are all valid reasons to exercise options, but you will want to be sure that exercising the options is the best way to raise this cash prior to exercising.
Some strategies to consider
When exercising employee stock options, you can always pay cash to purchase the shares.
Beyond this, there are a few common strategies you can consider:
- A cashless exercise occurs when vested options are exercised and the shares are sold immediately. Any excess cash from the transaction would be deposited in your account.
- A cashless hold means you exercise a sufficient number of options to sell some of the shares. The cash from the sale will cover the cost of the remaining shares.
- Let the options expire If the strike price is higher than the current market price of the shares, it makes no economic sense to exercise the options.
Employee stock options can be a lucrative form of compensation, especially if the company’s shares appreciate nicely over time. Understanding the ins and outs of managing and exercising these options can help enhance their value.