If you've been offered stock options as part of your compensation package, you probably have a lot of questions about if, when and how to exercise them. Stock options can be a powerful investment tool because they allow you to purchase stock in your company at a discounted rate. However, they also come with risk and potentially significant tax consequences.

Employee Stock Options Basics

There are two types of stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). Both types allow you to purchase stock in a company at a reduced rate, but there are some key differences.

NSOs can be awarded to both company employees and non-employees like contractors, suppliers, lawyers, etc. In this way, NSOs can be distributed as a sort of payment for services rendered or as an employee bonus. Gains from NSOs are taxed at ordinary income rates.

ISOs—also sometimes called qualified stock options (QSOs)—differ from NSOs in terms of eligibility and tax treatment. ISOs are only available to employees of a company and, as long as they are had for at least one year, are eligible for more favorable taxable gains rates, rather than income tax rates.

Key Stock Options Terms

Whether you're new to stock options or trying to better understand the nuances between the various types, there’s terminology involved that can get a little confusing. This glossary of terms can help you gain a better understanding of your options (no pun intended).

  • Exercise: The process of acquiring shares via stock options.
  • Expiration date: The date your stock options expire. You must exercise your options and acquire shares before this date.
  • Grant date: The date the company makes the stock options available to you.
  • Exercise price (a.k.a. grant price): The discounted price at which you are eligible to purchase stock.
  • Bargain element: The difference between the market price of your stock and the exercise price.
  • Capital gains: Profits from the sale of stocks in excess of their original purchase price. When you sell stocks for more than you paid for them, the difference is your capital gain.
  • Vesting period: The period of time after the grant date one must wait before being allowed to exercise a specific number of shares.
  • Fully vested: The point in time when you are able to exercise 100% of the stock options you were granted.

How Non-Qualified Stock Options Work

Typically, a company will grant you stock options, which simply means they are giving you the opportunity to purchase company shares at a specific price during a specific window of time. These options may also come with a vesting period, or waiting period, before you can purchase the full amount of optioned shares.

As your shares vest, or once the vesting period is over, you have the opportunity to purchase the shares at the exercise price. Ideally, you will wait to exercise your option at a point where the market price of the stock exceeds the exercise price. You don't want to wait too long, however, as stock options have an expiration date, after which they can no longer be exercised.

Benefits of Non-Qualified Stock Options

With NSOs, you get the opportunity to buy stock at a fixed price that is lower than market value. This provides instant growth in your investment.

In the example below, the individual purchasing stock options earns $250,000 and is in the 32% income tax bracket and 15% capital gains bracket.

  NSO Purchasing Stock on Market
Number of Shares 500 500
Price Exercise Price: $50 Fair Market Price: $75
Amount out of pocket to purchase on 1/1/2019 ($25,000) ($37,500)
Taxes paid with purchase: difference between fair market price and exercise price taxed as ordinary income rate ($4,000) $0
Total out of pocket ($29,000) ($37,500)
Value of stocks on 1/1/2019 $37,500 $37,500
Net after investing $8,500 $0
Stock price on 1/31/2019 = $100    
Gross from sale of $500 stock $50,000 $50,000
Total cost basis (amount actually paid, plus amount of income taxed) ($37,500) ($37,500)
Taxable gain $12,500 $12,500
Tax rate 32% 32%
Taxes due $4,000 $4,000
Net after taxes paid on gains $8,500 $8,500
Plus net value gained after investment $8,500 $0
Net gain from transaction $17,000 $8,500

 

Since NSOs are not tax-advantaged, however, it is important to consider the tax ramifications of utilizing them.

Tax Treatment of Non-Qualified Stock Options

There are a few nuances to how NSOs are taxed. Things like income, how long you’ve held onto your shares, and capital gains all affect how you’re taxed, so here are a few things to keep in mind:

When do I have to start paying taxes on my NSOs?

The first taxable event comes when you exercise your options to purchase shares. You are not immediately taxed on the grant date or when your option is fully vested. You don’t start getting taxed until you purchase shares.

How am I taxed once I decide to buy shares?

Once you exercise your stock option by purchasing stock, the difference between the fair market price of the stock and the exercise price will be taxed as ordinary income.

For example, say your employer gives you the option to purchase 500 shares of stock at an exercise price of $10 per share. One year later, the market price of the stock is $20 and you exercise your options by purchasing all 500 available shares at the lower exercise price. You now own $10,000 worth of shares for which you only paid $5,000.

The difference between what you paid for the shares ($5,000) and what they’re worth ($10,000) is called the bargain element and is taxed as ordinary income—even if you don't sell any of the shares. If your ordinary tax rate is 28%, then you'll pay $1,400 of income tax and will have spent a total of $6,400 to purchase $10,000 worth of stock.

Now that you own the stock and have paid taxes on the bargain element, your cost basis $20 per share, or $10,000 in this example.

Do I have to pay taxes when I sell my shares?

Yes. When you sell your stock, you will pay taxes on any realized capital gains.

If we stick with the example above, the fair market value of the stock when you purchased it was $20, and you paid ordinary income tax on the bargain element. Now, fast forward six months: The fair market price of the stock is $25 per share, and you decide to sell all 500 shares.

Normally, to determine your cost basis of an investment, you'd take the amount you sold the stock for (500 shares at $25 per share makes $12,500) minus the amount you originally paid to purchase the shares ($5,000) to get taxable gains of $7,500. But, lucky you, you also already paid taxes on the difference between the $10,000 market price and the $5,000 exercise price at the time of purchase. So, as far as the IRS is concerned, even though you only spent $5,000 out-of-pocket, you paid taxes on the full $10,000, and that becomes your cost basis.

To determine how much taxable capital gain you have, take the amount you sell the stock for ($12,500) and subtract the cost basis of $10,000 (the $5,000 you paid and the $5,000 bargain element you paid ordinary income tax on) to get your taxable gain of $2,500.

The Best Time to Exercise Your Stock Options

There’s really no set rule about when to exercise NSOs—it’s a judgment call. While it might be tempting to exercise your options as soon as you can or when you think the market price is at a peak, there are other things to consider.

Can I afford to exercise my options right away?

If we continue with our earlier example, and you have the option to buy 500 shares at a grant price of $10 per share, but the market price is $20 per share, you’ll have $10,000 worth of stock for only $5,000.

While it’s a savvy business move to exercise the option, you still need that $5,000 worth of disposable income to buy those shares. If you don’t have that in savings (where it’s accruing risk-free interest), you’ll have to borrow it, which means you’ll have to pay it back—plus interest. 

Further, when you exercise the option, you’re taxed on the difference between the fair market price of your shares and the grant price. The IRS treats that difference as ordinary income, so you’re taxed on it at your normal income tax rate—which means you’ll actually need $6,400

So, does it make sense to exercise my options in lower income years?

If possible, it can be smart to exercise options in years when your income is lower to minimize how much you'll owe in income tax when you buy those shares. You’ll need to make sure you have enough saved up to afford the initial stock purchase, but this strategy can save you a lot in taxes—especially if you move down a tax bracket.

What if I wait to exercise my options?

In some cases, waiting until the expiration date to exercise your options can be the best course of action, especially if your goal is to immediately sell your shares for a large capital gain.

This is the best way to see an immediate return on your investment. However, you could be leaving money on the table if the price of your shares continues to climb, and you’ll also likely have to pay more in taxes by missing out on long-term capital gains rates.

What are long-term capital gains rates?

Capital gains are the profits you get from selling your stock. Long-term capital gains come from selling stock held for one year or more, while short-term capital gains come from selling stock held for less than a year.

The length you hang onto your stocks affects how you’re taxed. Short-term capital gains are taxed as regular income (so you’re taxed at the same rate when you sell your shares as you were when you bought them), but long-term capital gains are subject to more favorable tax rates.

Long-term capital gains rates can minimize the amount of tax you pay, meaning you end up with a greater net capital gain and more money in your pocket.

Do I have to exercise my options all at once, or can I spread them out over time?

You can definitely spread them out over time. In fact, doing so has its advantages. If we continue with the above example, rather than purchasing all 500 shares at once, you can spread those purchases out and exercise 100 shares a year for five years—assuming the expiration date is more than five years away.

By exercising your options over time, you won’t see any immediate or significant gains, but you can reduce a lot of the upfront costs and spread out the tax liability.

So, shouldn't I then wait until market conditions are more favorable?

It’s a fool’s errand trying to time the markets. You might exercise your options and expect the price of your shares to go up, but they could go down. You might end up leaving money on the table by waiting to sell or selling too early, or you could even lose money.

That’s why diversification is so important. No matter how strong your company is, it can be risky to invest heavily in one stock, so it’s important to use your stock options as one part of a comprehensive financial plan. In other words, don’t put all your eggs in one basket, and don’t rely on NSOs as your only type of investment.

Next Steps

Investing is far from an exact science, and there are a number of factors that go into how and when you should exercise your NSOs. Working with a financial advisor will help you determine the right approach for you and ensure that you aren't needlessly losing your investment—to taxes or otherwise.

 

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

This article was originally published in August 2019.

Timothy Hewitt

Timothy Hewitt

Vice President, Financial Advisor

CFP® Timothy enjoys partnering with clients to uncover their concerns, understand their priorities and help them accomplish their goals. He is well versed in all areas of wealth management but specializes in taxation and real estate. Tim shares his expertise through coaching team members, speaking engagements and client activities. He enjoys helping others and the community through his involvement with the Volunteer Income Tax Assistance program and the Financial Planning Association....Read More