As part of your compensation package, your company might offer you stock options to supplement your salary. While they can be a valuable form of compensation, they also leave you with plenty of decisions to make about how and when to use them. It’s important to understand the ins and outs of stock options to get the most out of them and get ahead of any potential tax consequences.
What is a stock option?
A stock option is a contract that gives you the right to buy a certain number of shares of company stock at a set price after some future date. If your company’s stock increases in value between now and then, you can buy shares for less than they’re worth. You can then hold on to the stock in hopes it continues to gain in value, or you can sell and pocket the profit.
Stock options are an attractive form of compensation to employers because they give employees an incentive to remain with the company at least until their options become available. They also incentivize employees to work hard to increase the value of the company, which will effectively increase the value of their options contract.
Historically, stock options were offered almost exclusively to executives. More recently, it’s common for other employees to receive stock options, as well. For example, start-ups, which may not have the budget to pay competitive cash salaries, frequently supplement their employee compensation packages with stock options.
The key elements of a stock option contract are:
- Grant date. The day you receive the options contract. Important milestones in the contract are defined in terms of the grant date.
- Strike price. The price per share you will pay if and when you exercise your executive stock options. The strike price is often the fair market value of the stock on the day the board approves the options contract.
- Number of options. The total number of shares being offered at the strike price.
- Vesting schedule. How long you must wait for some or all of your options to become available or “vest.”
- Exercise period. The amount of time you have to exercise vested options before they expire.
How stock options fit into your investment portfolio
Exercising your options for less than the shares’ fair market value can be a boon to the value of your investment portfolio. But beware: Holding a large position in one stock can lead to an unbalanced portfolio and expose you to greater risk should that stock perform poorly. For this reason, many people exercise stock options and immediately sell some or all of their shares, using the gains to buy a more diverse set of investments.
Exercising your options
To take advantage of your stock options, you need to be able to fund the purchase of your vested shares. Fortunately, there are ways to exercise your options even when you don’t have cash on hand. You can ask your brokerage firm to buy the options and then immediately sell enough shares to fund the transaction. Additionally, your brokerage firm could exercise the options and immediately sell them all, covering costs and sending the leftover cash to you.
Stock options and taxes
There are two types of stock options. Nonqualified stock options (NSOs) are the most common, and they confer no special tax advantage. When you exercise NSOs, you will owe income tax on the difference between the strike price and the fair market value. You don’t have to sell the NSOs to trigger this tax. When you do sell, any taxable gains or loss will be measured from that fair market value at the time you exercised your options.
Conversely, incentive stock options (ISOs) do offer a tax advantage. Exercising them won’t trigger income taxes as long as you hold on to them for at least a year. If you hold them for less than a year, they will be treated retroactively as NSOs. When you finally sell, any taxable gain or loss will be measured from the strike price.
Executive stock options are potentially quite valuable, but exercising them can have implications for your portfolio and your tax bill you’ll need to consider. While you’re waiting for your options to vest, do your homework and talk to a financial professional who can help you decide the best way to use them.