Ready to Exercise? Non-Qualified Stock Options and Incentive Stock Options
Stock options are a form of compensation that offers employees the potential opportunity for personal financial benefit that's in alignment with a company's success. Understanding stock options, the terminology, and what to do with them can be complex; hopefully the following will provide some clarity.
What are stock options?
Stock options grant employees the right, not the obligation, to buy a specific number of shares of company stock at a predetermined price, known as the strike price or exercise price. The exercise price is typically set at the market price of the stock on the date of grant. However, the employee can exercise the options and purchase the stock at a later date, usually after a specific vesting period has passed.
Before getting too far into the details, some key terms:
Grant date: the date on which the stock options are granted to an employee.
Vesting: the period of time after the grant date that must pass before employees are allowed to exercise a given number of shares.
Vesting schedule: the timeline or pattern outlining when an employee's stock options will become exercisable or vested. It may be based on years of service or a specific schedule, such as 25% vesting each year over a four-year period (commonly referred to as "1-year cliff, 4-year vesting").
Cliff vesting: a vesting schedule where employees become fully vested in their stock options after a specific period. If an employee leaves before the cliff period, they forfeit all unvested options.
Exercise: the act of purchasing the stock granted by the stock option.
Exercise price or strike price: the price at which an employee can purchase the company stock.
Exercise period: the timeframe during which an employee can exercise their vested stock options. This period may last a few years after the options have vested.
Expiration date: the last date by which an employee must exercise their stock options before they expire. Typically, this date is several years after the grant date.
In-the-money: When the current market price of the company's stock is higher than the exercise price of the employee's stock options. The options have intrinsic value.
At-the-money: when the current market price of the underlying stock is approximately equal to the exercise price of the stock options.
Out-of-the-money: the opposite of in-the-money. It means the current market price of the company's stock is lower than the exercise price of the employee's stock options, and the options have no intrinsic value.
Bargain element: the difference between the market price of the company's stock at the time of exercise and the exercise price.
Stock option pool: the number of shares set aside by a company for future issuance as stock options to employees, consultants, or directors.
Dilution: the reduction in existing shareholders' ownership percentage due to the issuance of additional shares, such as when stock options are exercised.
Stock option agreement: a legal document outlining the terms and conditions of the stock options, including the grant date, vesting schedule, exercise price, expiration date, and any other relevant provisions.
What are some of the benefits of stock options, and why do businesses offer them?
Potential Financial Gain: If the company's stock price increases above the exercise price, employees can purchase shares at a lower cost and sell them at a higher price, resulting in a financial gain.
Aligning Interests: Stock options align the interests of employees with those of the company's shareholders, as both parties benefit from the stock's price appreciation.
Retention and Motivation: Stock options can serve as an incentive for employees to remain with the company long-term and work towards its success.
What are some of the drawbacks of stock options?
Potential Financial Loss: Stock prices can be volatile, leading to potential losses if the market value of the stock decreases below the exercise price.
Decreased Diversification: Depending on the employee's level of ownership, stock options can result in an over-concentration of wealth in a single investment, potentially increasing risk.
Limited Control: Employees have limited control over the timing of when to exercise their stock options, as it is dependent on vesting schedules and market conditions.
There are two primary types of stock options: Non-Qualified Stock Options (NQSOs) and Incentive Stock Options (ISOs)
Non-Qualified Stock Option (NQSO or NSO)
NQSOs are subject to ordinary income tax on the difference between the exercise price and the fair market value of the stock at the time of exercise, the bargain element. The difference may also be subject to payroll taxes. Any subsequent gains or losses upon selling the stock are treated as capital gains or losses. NSOs can be exercised at any time after vesting. Vested shares are available for exercise after separation from the employer, with potential restrictions.
Incentive Stock Option (ISO)
ISOs offer potential tax advantages compared to NSOs. If certain conditions are met, such as waiting a year from the exercise date and at least two years from the grant date, employees may qualify for long term capital gains tax rates upon the sale of the stock. No ordinary income tax is due upon exercise, but the spread between the exercise price and the fair market value of the stock is considered an adjustment for Alternative Minimum Tax (AMT) purposes. ISOs are typically granted to employees only and have a maximum limit of $100,000 vesting in a calendar year.
Should you sell or hold onto my stock options?
Each individual's circumstances, goals, and needs are different. Before making a decision to hold or sell, consider the following reasons one might choose to exercise and sell stock options:
Cash Flow Needs: Selling in-the-money stock options provides an opportunity to generate immediate cash.
Diversification: Selling options allows employees to reduce the risk of over-concentrating wealth in a single investment. Consider also that if things go poorly for the employer's stock, layoffs and a loss of salary may coincide with a drop in the stock value.
Market Conditions: Selling options can be a wise choice if market conditions are uncertain or if the stock price has reached a favorable level.
Consider some reasons for holding onto the stock options:
Potential for Future Gain: If employees believe that the stock price will increase significantly in the future, they may choose to hold onto their options.
Tax Considerations: Holding onto ISOs can allow employees to qualify for more favorable tax treatment if the holding period requirements are met.
Stock options can be an incredibly valuable form of compensation for an employee's hard work and loyalty to an employer. It is important to consider the tax ramifications of the exercise and sale of stock, the future prospects of the company issuing the stock options, and how the asset might support the employee's financial goal plan. If you have any questions, it might be a good time to speak with a financial planner or tax professional.
My name is Tim Melia, and I am a CERTIFIED FINANCIAL PLANNER™ Professional. I would be happy to answer any questions you may have or discuss how this topic impacts your life and financial goals. Feel free to email me at tim.melia@emboldenfp.com. If you would like to learn more about working with Embolden Financial Planning LLC, please schedule a free, virtual introductory meeting.
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References
“Non-Qualified Stock Options Taxation.” Wealth Enhancement Group, 5 July 2020, www.wealthenhancement.com/s/blog/non-qualified-stock-options-taxation-MCSRY2C4B4V5DYFNI4UGHDG2CXWY.
Lam-Balfour, Tiffany. “Incentive Stock Options (ISOs): Taxes and Benefits - NerdWallet.” NerdWallet, 21 Mar. 2023, www.nerdwallet.com/article/investing/isos.
"Stock Options." Internal Revenue Service, www.irs.gov/taxtopics/tc427
