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Purchase a share in your company for a fixed price. You might even turn a profit.
Employee stock options provide you with a way to profit if your company is successful.
You must act on your options by exercising them, or else they have no real value.
Non-qualified stock options and incentive stock options have different tax implications.
The dates of transaction also play a role in determining how much tax you’ll pay.
As part of your employment contract, you may have been granted employee stock options. The prospect of investing in stocks might sound intimidating or confusing, but once you understand the key terms you’ll be able to make decisions in confidence that could even make you some money.
Stock options are a common way for companies to compensate employees. If you have employee stock options, that means that you can purchase a share in your company for a pre-established price that is often below the market value. When the company goes public, you might be able to make a profit.
In this article:
Employee stock options are a contract from your employer that enable you to buy a specified number of shares of company stock at a fixed price, within a certain amount of time.
The exercise price (also called the grant price or strike price) at which you can buy company stock does not ever change, even though the actual market value price of the company stock will. In fact, in the best circumstances the market value will rise to be much greater than the exercise price, putting you and your shares “in the money,” or with the potential to earn big.
But, before you can do anything, you must wait for your employee stock options to fully vest. Employee stock options become available at a steady rate over time, until the full amount is available to you on your vesting date.
Vesting schedules are set by your company. For example, a vesting schedule might be four years with a one-year cliff. This means you will have to have to wait at least one year for a portion of your options to vest at all. Then, going forward, the remaining options will vest at a consistent rate over the following months until you’ve accumulated all the shares at the end of the four-year vesting period.
When your options have vested, you’ll need to exercise them — actually buy shares of stock before you can sell them. If you don’t, your options will sit around without generating any money.
Employee stock options don’t last forever. You will not be able to exercise options after the expiration date, typically 10 years from the grant date. After you leave the company, whether voluntarily or not, you may face a window of time (usually 90 days) during which you can exercise your options.
We’ll use the following made-up details as a sample throughout the article.
Once your options have vested, you can finally buy company stock. This may be the day that you’ve been waiting for, but you aren’t obligated to exercise your options if you don’t want to. You can continue to hold them if you’re waiting for a higher market value price.
But if you think the time is right to exercise your options, here’s what you can do.
Exercise your options to purchase shares of company stock. Pay cash or write a check for $1,000 to purchase all 1,000 shares of stock. Keep in mind that you don’t have to purchase all the shares at once.
With this transaction, you exercise your options to buy company stock, then immediately sell those shares. You won’t have to front any cash, since the transaction is happening all at once. That’s why it’s called a cashless sell exercise.
Instead of paying $1,000 upfront for 1,000 shares, behind the scenes your option will be exercised for those 1,000 shares, which are then sold for the market price ($5,000 total). You’ll receive cash profit of $4,000.
Exercise your options and sell only enough to cover the purchase price. For this example, you would receive 1,000 shares of stock at the strike price of $1 each, then sell only enough to cover $1,000. That means you’ll sell just 200 shares, which at the $5 market price totals $1,000.
None of the above examples include fees that your brokerage might charge. Nor do they include taxes, which we’ll cover next.
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Your employee stock options are usually affected by the following types of tax:
The tax implications will depend on whether you have a non-qualified stock option (NSO) or an incentive stock option (ISO). We’ll discuss both of these next.
Non-qualified stock options are the more common type of option and can be offered to advisors and contractors, not just employees. They do not have tax incentives and will be taxed as income.
Exercising non-qualified options is a taxable event. Your taxable income will increase by the difference between the strike price and market price of stock on the day you exercised your option. This is called the compensation element or bargain element.
Bargain element = market value price at exercise date - strike price
Using our example: If you bought all 1,000 shares at a $1 strike price, and the actual market value of a share on this day was $2, the compensation element would be $1,000.
Bargain element = ($2-$1) x 1,000 shares = $1,000
The $1,000 compensation element will be added to your taxable income.
You’ll pay a tax on your capital gains — the difference between how much you sold the shares for, and how much they were worth on the exercise date.
If you sold all 1,000 shares for $5,000 and the price on the exercise date was $3 per share, the capital gain was $2,000 ($5,000-$3,000).
The type of tax you will pay is based on how long you held the shares. That’s the length of time between exercising (remember, that’s buying) the options and then selling them.
Long-term capital gains tax rates for single filers and head of household:
|Long-term capital gains tax rate||Income (single filers)||Income (head of household)|
|0%||$0 to $39,375||$0 to $52,750|
|15%||Over $39,375 but less than $434,550||Over $52,750 but less than $461,701|
|20%||$434,551 or more||$461,701 or more|
|Long-term capital gains tax rate||Income (married filing jointly)||Income (married filing separately)|
|0%||$0 to $78,759||$0 to $39,375|
|15%||Over $78,759 but less than $488,850||Over $39,375 but less than $244,426|
|20%||$488,850 or more||$244,426 or more|
Typically reserved for more high-level employees, the less common incentive stock option (ISO) comes with some tax advantages. Incentive stock options are also called a qualified stock options.
Exercising incentive stock options is not a taxable event. But high-income earners who take many deductions could be subject to the alternative minimum tax (AMT). The AMT may be assessed on the bargain element ($1,000 in our example) we discussed before.
If you meet the holding period requirements, then you may only have to pay capital gains tax instead of income tax. This is advantageous because the long-term capital gains rate is lower than the income tax rate.
You will have to pay income tax on your sale if you held the stock for less than one year.
You can pay long-term capital gains rates on your sale if you:
As for our example, let’s say you exercised all 1,000 options and sold them for $5,000 a few months later. The price on the exercise date was $3 per share, making your capital gain $2,000 ($5,000 from the sale - $3,000 exercise price). Your gain would be subject to ordinary income tax.
After you’ve exercised your incentive stock options, here’s a look at how you might be taxed.
|Hold shares||No applicable capital gains tax; possible AMT|
|Sell shares within a year||Income tax on bargain element|
|Sell shares within a year, but less than 12 months after exercising||Income tax on bargain element|
|Sell shares after holding for a year, but less than two years after the grant date||Income tax on bargain element|
|Sell shares after holding for a year, and two years after the grant date||Long-term capital gains tax on bargain element|
How long you hold your options and sell your shares depends on your individual circumstances. Depending on the type of stock options you’ve been granted, you should consider what taxes you’ll pay and how much. You can try to minimize your taxes by holding onto the stock for more than a year to qualify for capital gains tax as opposed to ordinary income tax.
It’s hard to predict how successful your company will be in the future, and perhaps even harder to be unbiased if you work there. In addition, while you might want to wait for the stock’s market value to rise, you should also keep in mind that your options have a shelf life.
Think about how much risk you’re willing to take on and set realistic expectations. While you could make substantial profit with your employee stock options, they shouldn't limit you from diversifying your assets by investing in other stocks and securities, or saving for retirement.
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