What They Really Mean

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Congratulations! Your compensation package includes employee stock options. Now what? Understanding stock options and how they work can get pretty tricky — but you can master the topic. And because it involves money, particularly yours, it’s a good idea to know what you’re doing. Take a look through the information below and you’ll be on your way to becoming an expert.

Types of stock options

Nonqualified stock options

These are the stock options of choice for broad-based plans. Generally, you owe no tax when these options are granted. Rather, you are required to pay ordinary income tax on the difference, or “spread,” between the grant price and the stock’s market value when you purchase (“exercise”) the shares. After that, any appreciation in the stock is taxed at capital gains rates when you sell. Keep the stock for more than a year and you’ll have a long-term capital gain, taxed at a top rate of 20%; hold for one year or less and your gain is short-term, taxed at higher, ordinary income tax rates. Nonqualified options can be granted at a discount to the stock’s then market value. They also are “transferable” to children and charity, provided your company permits it.

Incentive stock options (ISOs)

These are also known as “qualified” stock options because they qualify to receive special tax treatment. No income tax is due at grant or exercise. Rather, the tax is deferred until you sell the stock. At that point, the entire option gain (the initial spread at exercise plus any subsequent appreciation) is taxed at long-term capital gains rates, provided you sell at least two years after the option is granted and at least one year after you exercise.

If you don’t meet the holding period requirements, the sale is a “disqualifying disposition” and you are taxed as if you had held nonqualified options. The spread at exercise is taxed as ordinary income, and only the subsequent appreciation is taxed as capital gain.

Unlike nonqualified options, ISOs may not be granted at a discount to the stock’s then market value, and they are not transferable, other than by will.

Two warnings apply here:

  1. No more than $100,000 in ISOs can become exercisable in any year.
  2. The spread at exercise is considered a preference item for purposes of calculating the dreaded Alternative Minimum Tax (AMT), increasing taxable income for AMT purposes. A disqualifying disposition can help you avoid this tax.

Employee Stock Option Basics

An employee stock option is the right given to you by your employer to buy (“exercise”) a certain number of shares of company stock at a pre-set price (the “grant,” “strike,” or “exercise price”) over a certain period of time ( the “exercise period”). Most options are granted on publicly-traded stock, but it is possible for privately-held companies to design similar plans using their own pricing methods. Usually the strike price is equal to the stock’s market value at the time the option is granted, but not always. It can be lower or higher than that, depending on the type of option.

Employees profit if they can sell their stock for more than they paid at exercise. Most stock options have an exercise period of 10 years. This is the maximum amount of time during which the shares may be purchased, or the option “exercised.” Restrictions inside this period are prescribed by a “vesting” schedule, which sets the minimum amount of time that must be met before exercise. Most options are fully vested after the third or fourth year. Whenever the stock’s market value is greater than the option price, the option is said to be “in the money.” Conversely, if the market value is less than the option price, the option is said to be “underwater.”

When to exercise

Conventional wisdom holds that you should sit on your options until they are about to expire to allow the stock to appreciate and, therefore, maximize your gain. But many employees can’t wait that long. One study found that the typical employee cashed out of his options within six months of becoming eligible to do so, thereby sacrificing an estimated $1 in future value for every $2 realized. There are legitimate reasons to exercise early. You may have lost faith in your employer’s prospects and, therefore, its stock. You may be overdosing on company stock. It is unwise to keep more than 10% of your portfolio in employer stock.

Exercising stock options

There are three basic ways to exercise options: pay cash, swap company stock you already own, and engage in a cashless exercise.

Cash

This is the most straightforward route. You give your employer the necessary money and get stock certificates in return. But what if, when it comes time to exercise, you don’t have enough cash on hand to buy the option shares and pay any resulting tax?

Stock swaps

Some employers let you trade company stock you already own to acquire option stock. Say your company stock sells for $50 a share and you have an ISO to buy 5,000 additional shares for $25 each. Instead of paying $125,000 in cash to exercise the option, you could exchange 2,500 shares (with a total market value of $125,000) you already own for the 5,000 new shares. This strategy has the additional benefit of limiting your concentration in company stock.

Cashless exercises

This is where you borrow from a stockbroker the money needed to exercise your option and, simultaneously, sell at least enough shares to cover your costs, including taxes and broker’s commissions. Any balance is paid to you in cash or stock.