By Landon Fritch, CFP® and Tom Burleigh, CFP®, CTFA
Your paycheck pays the bills, but your stock options could build real wealth. So, what’s the catch? Between vesting schedules, exercise prices, and complex tax rules, it’s easy to get lost in the details and miss out on their full potential. The good news is that with a little clarity, stock options can become one of the most rewarding parts of your compensation.
Unlocking the full potential of your stock options begins with understanding the basics. In this post, we’ll break down what employee stock options really are, how they work, and the key decisions you’ll face along the way so you can make confident decisions and avoid costly mistakes.
What Are Employee Stock Options?
Before diving into the different types of employee stock options, let’s start with the basics. A stock option is a contract between you and your employer, often called a grant or award. It gives you the right to buy company stock in the future at a fixed price, known as the strike or exercise price.
If the company’s stock price rises above your option’s strike price, you can profit by buying the shares at the lower price and either holding or selling them. To exercise options, you generally need the cash to purchase the shares. If you do not have the cash, some employers will allow you to do what’s called a cashless exercise. This is where you buy the shares and sell enough at the same time to cover the cost, leaving you with the remaining gain. Cashless exercises are more common at public companies, where shares are easier to sell.
Employees at private companies face a different challenge. Their shares usually require a liquidity event, such as an IPO or company sale, to be sold. In these cases, employees not only need to come up with the cash to buy the shares but may also have to wait months or years before converting those shares back into cash. Sometimes, employees may have to leave potential gains on the table if they can’t afford the purchase or leave before a liquidity event occurs.
The difference between the strike price and the market price on the day you exercise is called the spread.
The Two Types of Stock Options
There are two types of stock options offered to employees, known as non-qualified stock options (NQSOs) and incentive stock options (ISOs). The difference between the two has to do with how they are treated from a tax perspective.
Non-Qualified Stock Options (NQSOs)
Here are the key points to understand about NQSOs:
- When you exercise NQSOs, ordinary income taxes are owed on the spread.
- The income will show up on your W-2 as wage income.
- Your employer will withhold federal taxes at the supplemental wage rates, which is usually 22% but might be 37% for higher earners.
- You may owe additional tax beyond what is withheld, so it is important to work with your tax advisor to determine if a quarterly tax payment is needed.
- Exercising your options converts them into a capital asset.
- Depending on how long you hold the shares, any additional gain beyond the purchase price plus spread, may be taxed at either favorable long-term capital gains rates or ordinary income.
Incentive Stock Options (ISOs)
Some notable differences with ISOs are:
- They are less common than NQSOs and are often used to attract talent at startups and high-growth companies that sometimes struggle to match the compensation of larger competitors.
- Unlike NQSOs, no taxes are due when exercised.
- Spread may trigger alternative minimum tax (AMT), so it’s important to plan ahead with your tax advisor.
- If shares are held for one year from the date of exercise and two years from the grant date, the entire profit is taxed at favorable long-term capital gains rates. This is called a qualifying disposition.
- If these timing requirements are not met, part or all the spread is taxed as ordinary income. This is a disqualifying disposition.
- It’s important to know that after leaving a company, you generally have 90 days to exercise any vested ISOs. Missing this deadline could result in losing favorable tax treatment, or even the options themselves. For NQSOs, some companies may set a similar post-termination deadline, but for ISOs, the 90-day limit is required by the IRS
How Vesting Works
As with most stock incentive plans, stock options only have value once certain conditions are met. When those conditions are satisfied, the shares are said to vest, meaning they are now able to be exercised by the employee. Companies use vesting schedules to encourage employees to stay and to share in the company’s growth.
These vesting schedules come in different forms, but it is common to see a combination of cliff and graduated schedules where nothing vests for a set period followed by gradual vesting.
Suppose you are granted options for 100 Apple shares that follow a four-year vesting schedule with a one-year cliff, followed by quarterly vesting. For the first year, starting on the grant date, you cannot exercise any options. After year one you can exercise 25% of the shares. The remaining 75% of shares will vest equally over each of the remaining 12 quarters.
This is what it would look like:
Early Exercise (83(b) Election)
Typically, taxes are due when an employee’s vested stock options are exercised. However, if the company’s equity plan allows, employees can choose to pay taxes when the options are granted by filing an 83(b) election within 30 days of the grant. Doing so can reduce taxes if the stock increases in value before vesting, since the tax is based on the stock’s value on the grant date. Early exercising of shares is more likely to be done with non-qualified stock options than with incentive stock options due to the holding period requirements and the $100,000 rule, which we’ll explain next. A risk with exercising early is that you cannot get a refund of taxes paid. If you exercise early and the stock price later falls, your options could expire worthlessly, meaning you have already paid taxes on an investment that ends up with no value.
The $100,000 Rule
Incentive stock options come with a special IRS rule where no more than $100,000, based on the share’s fair market value on the grant date, may become exercisable in a single calendar year. Anything over $100,000 will automatically be converted into non-qualified stock options. This rule applies across all grants, so multiple grants will be aggregated. If your plan allows early exercise, then the entire grant is considered exercisable in year one, making it easier to go over the limit. Employers typically track and report which options are reclassified as non-qualified stock options.
Deciding When to Exercise or Sell Your Options
One of the hardest parts about having stock options is trying to determine how they fit into your retirement, savings, and wealth building strategies. Here are the key factors to consider:
- Type – Do you have ISOs or NQSOs?
- Vesting schedule – When will you be able to exercise them?
- Expiration date – Will your options be expiring soon? Most expire 10 years after the grant date.
- Value – Does the current stock price exceed the strike price? In other words, are the options even worth exercising?
- Cash availability – Do you have the funds to buy the shares, or will a cashless exercise be needed?
- Taxes – Will this create a large tax bill? Could AMT be owed if you have ISOs?
- Cash needs – Could selling help pay off debt, buy a home, fund retirement, or fund other goals?
- Concentration Risk – Does your company’s stock make up too much of your portfolio?
- Job Status – How long do you plan to remain with your employer? Leaving could accelerate deadlines or cause you to forfeit unvested shares.
- Company Performance – How do you feel about the future performance of the company?
As you can see, there are many factors to consider, and every individual’s financial situation is unique. A financial advisor can help you balance tax efficiency, risk management, and your long-term goals so you can make a prudent decision.
