If you've been offered Non-Qualified Stock Options as part of your compensation package, you probably have a lot of questions about if, when and how to exercise them. NSO's can be a powerful investment tool, because they allow you to purchase stock in your company at a discount but they also come with risk and potentially significant tax consequences. Before we begin, if you're new to NSO's, you might want to review our Employee Stock Option Primer.

The benefit is clear. You get the opportunity to buy stock at a fixed price that is lower than market value. This provides instant growth in your investment. Since NSO's are not tax-advantaged, however, it is important to consider the tax ramifications of utilizing them.

You Won't Be Taxed on the Grant Date

Since all you actually own on the grant date is the option to purchase stock down the road, there isn't any income yet to tax. You are just being granted an option that, in most cases, won't be vested yet. And, even once fully vested there, you have still not reached a taxable event. The first taxable event comes when you exercise your options to purchase shares.

You Don't Have to Sell to Be Taxed

Now for some bad news. One common misconception is that, when it comes to NSO's, you won't be taxed until you sell your shares. Unfortunately, that is not the case. Once you exercise your stock option, by purchasing stock you will be taxed on the difference between the fair market price of the stock and the grant price.

For example, say your employer gives you the option to purchase 500 shares of stock at a grant price of $10 each. One year later, the market price of the stock is $20 and you exercise your options and purchase 500 shares at $10. You now own $10,000 worth of shares which you paid $5,000 for. The IRS treats the difference between what you paid, here $5,000, and what you are worth, here $10,000 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.

You Also Have to Pay Taxes When You Sell

In addition to having a tax bill on the benefit amount when you exercise your options, you'll also owe taxes when you eventually sell your stock. When you exercise your option and purchase the stock, you are paying ordinary income tax on the value of the benefit you get from your employer in the form of a discounted grant price. Then, 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 difference between the exercise price and the market price. Now, fast forward 6 months and the fair market price of the stock is $25 a 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, $12,500 less the amount you paid—$5,000 in our example—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. 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, $35 per share for 500 shares or $12,500 and then subtract the $10,000 (the $5,000 you paid and the $5,000 you paid ordinary income tax on) to get your taxable gain of $2,500.

Timing is Everything

So, even though you paid income tax when you exercised your option, you still got company stock at a discount. But in order to maximize this benefit, you'll want to wait to sell... For a little while, at least. Gains from stock held for one year or more are eligible for more favorable long-term capital gains rates. Gains from stock held less than one year are taxed as regular income.

Stay Diversified and Have a Plan

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. If possible, it can be smart to exercise options in years where your income is lower to minimize how much you'll own in income tax when you exercise them. And no matter how strong your company, it can be risky to invest heavily in one stock so it is important to use your stock options as one part of a comprehensive financial plan. Working with an advisor will help you determine the right approach for you and help ensure that you aren't needlessly losing your investment, to taxes or otherwise.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

This information is not intended to be a substitute for specific individualized tax advice.

Stock investing involves risk including loss of principal

Timothy Hewitt

Timothy Hewitt

Vice President, Financial Advisor

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.