For some companies, offering employee stock options makes sense. Not only can it align employees with their employer, but it can be a slick way to boost a compensation package.
For employees, stock options can provide an enticing chance to invest some money and take advantage of the growth that happens within their company.
One problem is that stock options can feel complicated. Between the paperwork that can seem like it’s in another language and the info sessions that have a way of lulling one into a trance, employees might come away with more questions than answers regarding their plans.
One common confusion about vested stock options is the question about whether and when to exercise the options and buy the stock. Given the unpredictable nature of stocks, it can feel hard to know whether to hold onto the options, exercise and hold the investment, or to sell the shares and use the funds.
Making a decision about your stock options can be complicated, there are a few variables to consider. If the stock has soared you have the dilemma of deciding to exercise the option and hold the investment, hoping for continued growth. Or do you exercise the option and sell the stock for a profit?
On the flipside, if you’ve exercised your options and the stock performed poorly the question might become: Should I give this stock time to recover or should I sell?
When selling employee stock, there’s plenty to consider, including taxes, financial goals, and the overall diversification of an investment strategy. Here’s a discussion of each along with a primer on employee stock option programs.
What Are Stock Options?
While there are several different varieties of employee stock option plans, the general idea is that stock options give an employee the opportunity to purchase shares of their company’s stock at a discount. The discounted price is called the “exercise price.”
With an exercise price, a plan may allow employees to buy stock at a predetermined price, like $10, or at a discount to the value taken at some interval, like 10% off the value of a stock (as priced at a certain day of the year or quarter).
In general, each employee stock option allows for the purchase of one share of stock. To take advantage of a stock option program in the way it is intended, the employee would likely want to exercise the option (and buy the stock) when the exercise price is lower than the market value of the stock. The exercise price is generally pre-determined by the vesting schedule. By exercising the stock options the employee is given a chance to buy stock at a previously set price, regardless of the current market value of the stock.
Depending on the company program, an employee might need to be “vested” to exercise their stock options. Some companies may have multi-year programs where stock options vest over the course of several years. For example, a company may have an employee’s stock vest evenly, each year, over the course of five years. Each company will set its own vesting schedule. As the employee becomes vested, they are allowed to exercise their stock options. However, in some situations, as soon as an employee is granted a stock option they own it completely.
No need to wait until all stock options are fully vested to exercise the vested stock options. Generally, it is possible to exercise them as they become vested.
Here’s an example of how this might work.
Say that an employee is guaranteed 3,000 options at $5 per share over the next three years, delivered on a vesting schedule of 1,000 options per year. After the first year, 1,000 options vest. These stock options have an exercise price of $5 and the shares have a current market value of $10.
If they were to exercise these options now, they’d be buying 1,000 shares of stock at $5 per share or 50% off the current price of the stock. This spread is called the “bargain element.” Hypothetically, the employee could then turn around and sell the stock at $10 per share, earning $5,000 in the transaction. (This example is meant to be illustrative only.)
Though the market price of the stock may change in each of the next two years, the process is the same. Note that exercise options generally do expire. The details of expiration will usually be detailed in the initial contract. If you choose to exercise and sell your options you’ll also have to pay any commissions, fees, and taxes that are associated with the transaction.
Types of Employee Stock Options
For tax purposes, there are two primary categories of stock option plans—ISOs and NQSOs. To understand the difference, it can help to first know that there are multiple times throughout the process of exercising a stock wherein taxes may be levied.
Incentivized stock options (ISOs), which are also referred to as qualified stock options, are “qualified” for a preferential tax treatment. With ISOs, no taxes are due at the time of exercise (unless the investor is subject to Alternative Minimum Tax ), but taxes are assessed at the point in which the stocks are sold.
The capital gains tax rate applied depends on how long the stocks have been held.
Stocks that are held “long-term” are generally taxed at a lower rate than those that are held for the “short-term.” Therefore, some employees may see some benefit to holding their stock until they are considered to be long-term holdings.
To qualify for the long-term tax rate, the sale of the stock must be at minimum two years after the original grant date and one year and one day after exercise or purchase. They are then subject to the long-term capital gains rate , which is between 0% and 20% depending on an investors’ income.
Investments held less than a year are subject to short-term capital gains rates. Often, this means gains are taxed at an investors’ ordinary income tax rate, which can be higher than the rate investors will pay under the long-term capital gains tax rate.
To be sure, this can get complicated, so it may be a good idea to consult with a tax advisor. While the conditions above apply to most cases, there are exceptions based on an individual’s tax situation. For example, an investor who is subject to the AMT may take a different strategy.
Unlike ISOs, Non-Qualified Stock Options (NQSOs) do not have preferential treatment and are taxed twice. Unlike with ISOs, which are only taxed when the stocks are sold, the point of exercise is a taxable event.
During exercise of an NQSO, the employee pays ordinary income taxes on the difference between the market value and the cost to acquire the shares.
Then, when the employee sells the shares, proceeds are again subject to taxes at short-term or long-term capital gains tax rates.
Detailed information on the stock program, like the exercise price and vesting schedule, can be found in what is called a grant agreement. Also, employers may offer sessions to explain the mechanics of an employee stock program.
Even though they can be dense, employees should consider taking advantage of these programs, ask lots of questions, and familiarize themselves with the specifics of their unique plan.
Selling Employee Stock Options
With a grasp on what stock options are, now is the time to tackle the big question: When should a person sell out of their company stock? While each person’s situation is different, there are a few useful ideas to keep in mind while making the decision.
As mentioned above, one of the first considerations is the taxation of the stock. If there is any confusion about how a stock plan will be taxed, the employee should seek out an answer from either the plan administrator or a tax advisor.
Investors may receive a lower tax rate if they have owned the stock for more than a year. If an investor is still within the range of being taxed at a higher rate, they may make the decision to wait until they have held the stock for a period of time that allows them to qualify for the long-term capital gains tax rate.
(Again, this may not be the case if the investor is subject to the AMT. Check with a tax advisor to determine whether this is the case and if so, the appropriate course of action.)
Taxation may not be the only factor that investors want to take into consideration when selling stock. Investors may also want to consider what direction they believe that the stock’s price is headed, and take action based on that belief.
Making an accurate prediction about the price of a stock is notoriously difficult to do, even for a company at which a person works. All stocks are subject to stock market volatility, which isn’t always logical.
A stock’s price can fluctuate based on overall investor sentiment, which may or may not have much to do with fundamentals.
Consider two hypotheticals, one where an investor believes the price of their stock is going up in the future, and one where the investor believes that the price of their stock is going down in the future. In the first scenario, the investor may wish to hold onto their stock. In the latter, the investor may wish to sell their stock.
This comparison can also be made in relation to other asset classes. For example, an investor may believe that their stock will perform well, but that real estate values will perform better. Therefore, they may want to shift some of their focus to real estate.
There is also the consideration of diversification. An investor may not want to take the risk of being so heavily allocated to just one stock. With stock prices, anything is possible, no matter how sure of a bet it may seem. Anytime an investor loads up with one stock, they should be mentally and financially prepared to lose it all.
This advice rings especially true if the stock the employee owns belongs to the company for which they work. If something dramatic were to happen to a company, such as collapse, the employee could be out of a job—and their investment is also at risk of disappearing. Therefore, employees may want to consider periodically selling some of their stock and using the proceeds to create a diversified strategy.
Investing into a diversified strategy can mean different things for different investors. For some, diversification could be moving money into mutual funds or exchange-traded funds. For others, this could mean removing some money from the stock market altogether and allocating it to other investments, such as real estate.
Investors don’t have to wait for an employee stock payout to begin building a diversified investment strategy. Because of the unsure nature of employee stock programs, it may be a good idea to think of the after-tax profit on employee stock as an unexpected bonus, not a comprehensive approach to long-term financial planning.
An investor may simply want to sell stock because they have another financial goal in mind. An example of this is a person who wants to buy a home because they are starting a family and is ready to put down roots.
It’s generally a good idea for all investors to revisit their financial goals regularly and make adjustments to their strategy to best reflect those goals.
And when help is needed in making decisions about how to proceed, investors should not hesitate to reach out for help from professionals. Investors who are considering moving away from vested stock options and into real estate should consider the help of both a tax advisor and a lender that they can trust. A company like SoFi offers home loans and exceptional customer service for helping to navigate life’s changes.
Making big money moves can feel stressful, but they don’t need to be. SoFi’s mortgage loan officers (MLOs) can guide through the loan process, and as a bonus SoFi has financial planners available to answer any other personal finance questions.
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