You’re staring at a pile of paperwork about your company stock option plan, and it’s giving you a headache. Why does it look like it’s in a different language? What do these crazy instructions even mean?
Stock option plans can feel complicated and laden with technical terminology, and require strategic decision-making on behalf of the employee. And it sure doesn’t help that the information sessions about stock purchase plans provided by work are usually dry and overwhelmingly unhelpful.
Stock option plans come in two flavors: qualified and non-qualified, which refer to their taxation. Incentive Stock Options (ISOs) are qualified, and have a more favorable tax treatment than Non-Qualified Stock Options (NQSOs), which do not have as favorable taxation.
Despite the initial overwhelm, owning a company’s stock can be an exciting way to invest money. That said, it is important to understand how stock options work, including knowing when to exercise stock options.
The most common question about company stock plans is “When do I exercise stock options?” Here, we’ll look at the question and discuss how stock options can play a part of an overall financial plan and investment strategy.
What Are Stock Options?
Stock options give an employee the opportunity to purchase shares of their company’s stock at a specified price, called the exercise price. Each option allows an employee to purchase one share of stock. The benefit comes from exercising the option—buying the stock—when the exercise price is lower than the market value of the stock. Basically, an employee is given a chance to buy company stock at a set price when this occurs.
To exercise stock options, you must first be “vested.” Usually, stock options vest over a certain schedule. As you vest, you are able to exercise your stock options—to buy them at the exercise price (also called the strike or grant price). You don’t necessarily need to wait until all of your stock options are fully vested to exercise the ones that are vested.
Sometimes it is easiest to consider a simple hypothetical example. Say you have 100 fully vested stock options after a three-year waiting period. These stock options have an exercise price of $10 and have a current market value of $20.
If you were to exercise your options right now, you would buy 100 shares of stock at $10 per share or 50% off the current price of the stock. This is called the “bargain element.” You could then turn around and sell the stock at $20 per share, earning $1,000 in the transaction.
Stock options fall into one of two major categories, having to do with how they are taxed. To understand the difference, it helps to first know that there are really a few instances wherein a stock option could be taxed. The first of those is during the point of exercise. The second is when the purchased stocks have been sold. And finally, non-qualified stock options (NQSOs) can also be taxed at grant as well, which is when they’re given to the employee.
Incentivized stock options (ISOs) are “qualified” for preferential tax treatment. With ISOs, no taxes are due at the time of exercise (unless you are subject to AMT). Taxes are due at the point in which the stocks are sold, though the rate will depend on whether certain criteria are met.
If the sale is at minimum two years after the options were granted and one year after they were exercised, any gains on the transaction are subject to the long-term capital gains rate.
If the holding periods are not met, the proceeds may be subject to a higher tax rate—the ordinary income tax rate. The taxation of your stock options are not as simple if the holding periods described above are not met, or if you are subject to the alternative minimum tax (AMT). It’s a good idea to consult with a tax advisor.
NQSOs do not have preferential tax treatment. Unlike with ISOs, exercising stock options is a taxable event. At the point of exercise, the employee must pay ordinary income taxes on the difference between the market value of the stock on the date of exercise and the cost to acquire the shares. Then, when the employee sells the shares, proceeds are subject to short- or long-term capital gains taxes. Nonstatutory stock options can be taxed when granted as well—if the value can be readily attained.
Long-term capital gains taxes are lower; most people will pay either 0% or 15%, and the tax is capped at 20%. Short-term capital gains taxes are applied to investments held less than a year, long-term capital gains tax to investments held longer than a year. So, there is a tax incentive to hold onto investments for longer than on year.
The exact parameters of a company’s program will depend on how that company has set up their company stock option program. Details regarding your stock option program, such as the exercise price, expiration date, and vesting schedule, should be spelled out in what is called a grant agreement.
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When To Exercise Stock Options
The first step is to determine whether you can exercise them. Under most stock option programs, this will come after a designated vesting period. These programs operate similarly to a 401(k) match program; the idea is to reward only employees who have been at the company a certain amount of time.
Let’s say that your stock options are vested and any other required waiting periods are satisfied. Now, you have to decide whether to exercise your stock options now, or to wait until a later time.
All options come with an expiration date, which is the final date you can exercise the option. Plenty of people wait until the last moment to exercise their options, but you may want to exercise stock options earlier. This simply means that you make an active decision to exercise your options before the due date.
From a stock valuation standpoint, making this decision is notoriously difficult. It is hard to know whether a company’s stock is going to go up or down in the near future—even the company you work for. That’s because in the short-term, stock prices are at the mercy of stock market volatility, which often has more to do with market sentiment than it does with your company’s underlying business fundamentals.
Knowing Whether to Exercise Stock Options
Knowing this, there are a few ideas to keep in mind when deciding whether to exercise your options.
Do you foresee the value of the company stock declining in the near future? If this is the case, you may want to exercise your stock and sell your stock at a gain before the downturn.
Do you see your company’s stock increasing in the future? Perhaps you want to own as many shares of the stock as possible, so exercising options is a way to immediately own more of that stock.
Oftentimes, the decision about when to exercise stock options considers taxation. Because of this, it is always a good idea to consult a tax professional regarding your stock option plans.
One such example is if a person is to exercise a lot of NQSOs at once, pushing them into a higher tax bracket. For tax reasons, you may want to strategically exercise options in different tax years.
Additionally, because NQSOs are taxed at a higher rate during exercise and a lower rate when the stocks are sold, it may actually be strategic to exercise the stock options while the market price is somewhat close to the grant price.
This may seem counterintuitive because you aren’t then getting the best deal on the stock but remember that the bargain element is taxed at the income tax rate. Then, any ensuing gains made on the stock before selling will only be taxed at the long-term capital gains tax rate.
All of this said, it may not be a great idea to base your entire decision about whether to exercise stock options based on taxes. Stock options can be considered as part of a greater overall financial and investment plan.
It could be risky to have too much of your personal net worth tied up in your company’s stock. Generally, it is not recommended that any person keep more than 10% of their wealth in any one stock, in the event the stock doesn’t perform well or worse—the company goes belly-up.
This is especially true for the company that you work at. If something were to happen to the company that puts you out of a job, it could be potentially devastating to also have a large piece of your net worth tied up in that company.
If you have a large piece of your investment portfolio tied up in company stock, it is a good idea to have your eye on eventually moving at least some of this money into a diversified investment strategy.
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