- Stock options provide the owner of the option the right, but not the obligation, to purchase company stock at a fixed price, known as the exercise price, within a certain time period
- Employers may offer stock options to employees as part of a compensation plan, as an incentive for the employee to contribute to the company’s success.
- Employee stock could be a worthwhile addition to your portfolio, but you should consider the potential risks and tax consequences associated with exercising your options, as well as holding your employer’s stock.
Are you starting a job at a new company and reviewing your compensation package? Or perhaps your current company’s stock has undergone a recent change. If so, you may have heard about employee stock options.
Over the past three decades, stock options have become significantly more popular. The National Center for Employee Ownership says that the number of American workers holding employee stock options has increased by 900% over the past three decades.
Because of this, you may wonder about stock options and how to take advantage of them in your employee compensation package. This article will answer, “What are stock options?” and some details about this investment type offered in employee stock plans.
What Are Stock Options?
Stock options provide the ability to purchase shares of company stock at a predetermined, fixed price within a certain period. This fixed cost to purchase the stock is known as the exercise price or the strike price.
So, imagine that you own 100 options and that the current market price for one of these shares is $200. Your stock option, however, comes with an exercise price of $100, well below market value. If you exercise your stock options and sell them immediately, you’d profit $100 per share, leaving you with a $10,000 total profit.
Employee stock options are a type of option often offered exclusively by a company to its employees. Investors cannot find employee stock options on the open market. The U.S. Securities and Exchange Commission, describes employee stock options as “contracts between a company and its employees that give employees the right to buy a specific number of the company’s shares at a fixed price within a certain period of time. Many companies use employee stock options plans to compensate, retain, and attract employees.”
How Do Employee Stock Options Work?
Employee stock options operate as “call options” or having the right to buy (in contrast to “put options” which provide an investor with the right to sell). As an employee, you have the right to “call” and purchase the company stock at any time during a period before the option expires. However, you have no obligation to do so. If the price of the stock is not attractive — say there’s a market downturn or the company suffers from poor earnings, and the actual stock price is lower than the exercise price — then you can let the options expire without consequence. Here are important terms to understand about employee stock options:
Exercise price: The price at which you, the employee, can purchase the stock. The exercise price (also known as “strike price”) is fixed, but how the employer chooses to fix the exercise price can vary. Most select the market price of the stock on the day of issuance. However, some prefer to calculate a 60-day average.
Grant date: The date the employee is given the options subject to a vesting schedule.
Vesting date:The date when the employee owns the options and can begin to exercise, i.e. purchase the stock at the exercise price.
The vesting period is the time period during which you earn a portion of the options granted over time. Most companies have explicit rules about the vesting schedule. For instance, some companies may allow what’s known as “cliff vesting,” where you can earn your options all at once.
However, this would enable you to buy and then sell all of your shares hypothetically and then quit the next day. To prevent this, some companies implement graded vesting. For instance, you may only be allowed to vest 25% of your options each year for four years.
Expiration date: The date when you can no longer exercise the option. Companies often allow an extended expiration period for employee stock options. Some options have expirations of 10 years or more, allowing for the company’s growth and potentially higher share prices.
The option may also expire sooner than the stated expiration date, especially after the employee leaves the company. If you leave the company, you should consult with the human resources department to see if the options will expire within a 90-day time frame of leaving the company. Most companies do not allow employees to transfer stock options upon leaving.
Keep in mind that employee stock options do not have tangible value until you exercise them, only “intrinsic value” when the stock price is greater than the exercise price. To exercise the options, the company will typically direct employees to a specific brokerage account.
Because you’re buying an asset, you’ll need money when exercising options. You’re also responsible for the fees and taxes that come with selling a number of shares if you want to do so. If you don’t have cash, you can execute a cashless exercise strategy so long as there is enough intrinsic value to cover expenses and taxes. You could sell the stocks immediately after making the purchase in what’s known as an exercise-and-sell transaction. The brokerage will then return any earnings that remain after paying expenses and taxes on your behalf after the stock trades.
Are Employee Stock Options Subject to Taxes?
Once you purchase employee stock through your options, they are subject to taxation, just like any other income because the company, in essence, has given you a discount on purchasing the stock if the market price exceeds your exercise price. However, certain types of stock options will result in different tax treatments depending on when you buy and sell. Two of the primary employee stock option plans are non-qualified stock option plans and incentive stock options.
Non-qualified stock option plans (NSO) plans require you to pay ordinary income tax (plus Social Security and Medicare taxes; and state taxes, if applicable) upon exercising the option. You’ll typically pay taxes on the difference between the purchase price and grant price. When you sell shares, you’ll pay capital gains tax. If you held the shares for less than a year, you’d pay a short-term capital gains tax which is essentially the same as ordinary income tax rates.
If you sell the stock at least one year and a day after purchasing the stock, you’ll need to pay a long-term capital gains tax, which is 0%, 15% or 20% of the gain — generally more favorable tax rates than ordinary income — depending on your income tax bracket. You can read more about NSO taxation here.
Incentive stock options (ISO) require you only to pay taxes upon selling the shares if you follow certain rules based on how much time has passed between the grant date and the date the shares are sold. The time frame to remember to get the best tax treatment of ISOs is “one year plus a day after grant to exercise, and at least two years after grant to sell the stock.” If this time frame is followed, the sale is called a “qualified disposition,” meaning the transaction will qualify for the more favorable long-term capital gains.
However, If the qualifying disposition time frame is not followed, e.g. you sold your stock before the two years post-grant, the earnings are subject to ordinary income taxes. There is an additional catch with ISOs, thanks to something known as the Alternative Minimum Tax (AMT). If the alternative minimum tax assessed is higher than the regular income taxes resulting from the sale, then employees will also need to pay the AMT on the difference. This tends to come as an unwelcome surprise to many, so be sure to consult with a tax adviser if you think you will be impacted by these different taxes when exercising ISOs.
How Much Should You Put Into Employee Stock?
If you’re investing, you may be tempted to keep a good chunk of your portfolio in your employer’s stock. After all, you are there every day and may have a better sense of what’s going on with the company than any other. Believing in your company’s future is also motivational and admirable.
Consider carefully, however, before allowing a large percentage of your wealth to get tied up in a single company stock, including your employer’s. If your company were to go through hard times, your net worth would take a hit. The company could also slash expenses by laying off workers — leaving your income source vulnerable as well.
Diversifying risk is critical when investing. This holds true when dealing with employee stock by not holding so much of it that your wealth may not recover if things go wrong. Consider your entire portfolio and long-term future when weighing trading strategies for owning your employer’s stock.
Looking for More Investing Guidance?
If you’re new to investing, you may be curious about things like the stock market, how stock options work, and other investment information. If you’re looking to start investing confidently, experts recommend a few things.
First, do your homework and learn the basics about the market. Then, consult a financial planner for more guidance on how to grow your wealth based on specific, personal goals. Financial advisers can also explain the types of options and other benefits in your compensation package that you’re eligible for.
Lastly, you’ll also want to seek out a tax adviser. As mentioned above, the period of time during which you sell your shares is crucial toward determining your tax burden.
Your tax adviser can provide you with sound, unbiased advice, and guide you on which strategies you can use to potentially lower your tax bill. There are many advantages offered by your employee stock options, and with this knowledge and professional guidance, you’ll be in the best position to come out ahead.