Employee stock options are a common benefit in the tech industry. Not only do they incentivize employees to stick around, but employees benefit directly from their hard work in the form of ownership in company stock. Understanding stock options and how to incorporate them into your financial plan is a whole other story. For some individuals, their stock can become a large portion of their net worth as they can be extremely lucrative. This article will describe the basics of non-qualified stock options and incentive stock options, risks involved, and how to manage the tax consequences.
Before we dive into the details of non-qualified and incentive stock options, it’s important to understand the key terms often associated with them.
Key Terms to Understanding Stock Options
Grant Date: Typically, a company offering employee stock options will have grant dates for employees. Ownership isn’t given to employees straight out of the gate, they require a certain amount of time at the company before they’re granted.
Vesting: The date that the granted options “vest”, is when you gain full control of the options. Once vested, you’re able to choose when to “exercise” the right to buy your employers stock. The vesting schedule differs among employers, with some using a cliff, and others using a graded schedule. For example, a cliff schedule would vest all the granted options after 3 years, and a graded schedule would vest the granted options over a period of 5 years.
Exercise Price: The price at which you have the right to buy the stock once it’s vested. What makes stock options valuable, aside from the fact you’re getting additional compensation in the form of stock, is the “bargain element” received when you exercise. The bargain element is the difference between the exercise price and the market value of the stock at the time of exercising. For example, you may have a stock option that gives you the right to buy your employers stock at $10 per share, while the actual price of the stock is $20. That’s an immediate profit of 100% (not factoring in taxes).
Expiration Date: The date at which stock options expire. At some point, if you don’t exercise your options you’ll lose the right to buy the stock at the exercise price and the options disappear.
Types of Employee Stock Options
1. Non-Qualified Stock Options (NSO)
- NSO’s are generally offered to non-executives or key persons of a company.
- Granting of NSO’s is not a taxable event.
- Ordinary Income owed at the time of exercise on the “bargain element”, or the difference between the exercise price and the stocks current market price.
- When the stock is eventually sold, you pay capital gains taxes depending upon the amount of time you held the stock since exercising it. If held for less than 1 year you’ll owe ordinary income tax, and if held for longer than 1 year, you’ll pay the more favorable long-term capital gains rate.
2. Incentive Stock Options (ISO)
- ISO’s are generally offered to executives and key employees of a company.
- Granting of ISO’s is not a taxable event.
- Exercising ISO’s is not a taxable event. However, the dreaded AMT tax can apply to the “bargain element” of the exercised stock.
- When the stock is eventually sold, you pay capital gains taxes depending upon the amount of time you held the stock since exercising it. If held for less than 1 year you’ll owe ordinary income tax, and if held for longer than 1 year, the more favorable long-term capital gains rate. However, you also must ensure it’s been two years since the stock was granted to qualify for long-term capital gains.
How Do Stock Options Fit into My Financial Plan?
If you’re fortunate enough to receive stock options as a benefit through your employer it’s important to determine how they’ll fit into your overall financial plan. In order to maximize their benefits, you have to consider taxes, the stock’s value, and the risk you’re willing to take.
Taking advantage of long-term capital gains rates compared to ordinary income can help reduce the tax consequences of the stock options. That is if you’re willing or able to open yourself to the potential risk of holding a concentrated position for a longer period of time. The difference between paying ordinary income tax and long-term capital gains can be significant, especially for individuals in the highest marginal income tax brackets.
NSO’s upon being exercised is recognized as ordinary income. As a result, it can push individuals unknowingly into a higher tax bracket if their bargain element is great enough. Weighing the pro’s and con’s of doing so is an important consideration to make when exercising NSO’s.
ISO’s can potentially expose you to AMT taxes, the parallel tax code. The way the IRS views ISO’s is they’re essentially giving away the bargain element (the difference between exercise price and current market price of the stock) tax-free. In order to ensure people pay taxes on that compensation, they include it in the AMT tax. Consulting with a tax advisor or financial planner prior to exercising a substantial number of ISO’s can help you navigate the AMT tax.
When determining whether to exercise stock options you want to determine the future prospects of the stock itself. If the current market value of the stock is similar to or less than the exercise price, you probably won’t be exercising the option.
Depending on the expiration date of your options, you have time to wait and see how the stock performs. Remember, once the stock option is vested, you maintain the right to purchase the stock at the exercise price until the expiration date. If the stock performs better and rises above your exercise price, then you may consider exercising, especially if the long-term growth prospects are favorable.
Concentrated Stock Risk
With both types of stock options there lies a common risk. Stock option plans can create substantial wealth. What’s important to understand is the risk involved when that wealth is created. Individuals can end up with concentrated stock positions from their company. Not only do they rely on the company for income, health benefits, etc, but a large portion of their net worth ends up in the company stock. If something were to happen to the company, it could be catastrophic for an individual with concentrated risk.
The key is to diversify. Oftentimes, there remains an emotional connection to the stock. The company you’ve worked hard for has rewarded you with ownership and it’s built you great wealth! It’s a natural reaction. However, when it comes to investing you have to try and separate the emotional connections, from what you’re truly presented with as it relates to your financial plan and goals. For example, what if your financial advisor recommended you buy one stock that represents 50% of your net worth? Not that they would ever do that, but it represents the same situation from an analytical perspective. Whether the stock was bought using stock options or cash in a brokerage account, having 50% of your net worth tied up in one stock represents a substantial risk.
Diversification doesn’t necessarily mean you’ll earn less in return either when compared to a concentrated stock position. What it does mean- is your investment returns are being maximized for a given level of risk. Having a stock sell-off plan that manages the tax consequences in addition to diversifying over time is a key component of a financial plan that includes stock options.
Do you receive stock options as part of your compensation? Not sure how they fit into your financial plan or need help putting together a comprehensive financial plan in the first place? Schedule a free consultation with us today, and we’ll help you understand stock options and how they can help you reach your financial and life goals!
Levi Sanchez is a CERTIFIED FINANCIAL PLANNER™, BEHAVIORAL FINANCIAL ADVISOR™ and Co-Founder of Millennial Wealth, a fee-only financial planning firm for young professionals and tech industry employees. He is an avid sports fan, personal finance and investing geek, and enjoys a great TV show or movie. His mission is to help educate his generation about better money habits and provide financial planning services to those who want to start planning for their future today!