Stock options are a popular way for organizations to compensate their employees. They’re a convenient and cost-effective way to provide added value for the work that you do. Stock options also provide an incentive for employees to continue doing high-quality work for the company, because they tie a portion of your compensation to the company’s success. If the company does well, and the stock value rises, you’re in a good spot!
Unfortunately, stock options aren’t as cut and dry as other types of benefits or employee compensation. Your W2 income, for example, is taxed at your regular income tax rate. You withhold taxes with each paycheck and file your return every April. There’s never a question of whether your paycheck will show up, when you’ll have access to the funds, or how they’ll be taxed.
Stock options aren’t distributed or taxed with the same level of consistency. Although stock options can be a big financial benefit, it’s important that you understand how they work, and when to exercise them, to make the most of them.
What Are Employee Stock Options?
Employee stock options are exactly what they sound like – they’re an option that’s available to you to purchase a certain amount of company stock for a set price within a specific time frame. The price that your company offers the stock options to you is called the grant price. However, you won’t have the option to exercise your newly issued stock options immediately after you’re hired.
Companies like to create more incentive for you to stick around and keep working with them, so they may set your stock options to “vest” (or become available for exercise) after a set period of time. Once your stock options vest, you’ll have a set period of time to exercise them before they expire.
Many people want to exercise their options right away to create a windfall for themselves – like a cash bonus. While this may be the right move in some cases, it’s important to weigh your options before going through the exercise process.
4 Considerations Before Exercising
There are a few things to consider before exercising your stock options:
1. What type of options are they? Typically, you’re working with either an Incentive Stock Option (ISO), or a Non-Qualified Stock Option (NQSO).These two types of stock options are taxed differently, which means you should approach exercising differently depending on the type you have access to.
2. What type of taxes can you expect after exercising? When you exercise your ISOs, you don’t create a taxable event. So, you could feasibly hold onto the exercised options for a while, and pay long-term capital gains tax rates in a year or longer. NQSOs are counted as taxable income when you exercise, and you’ll still owe capital gains taxes when you sell them later.
3. Will the options gain more value if you delay selling exercising? It’s important to note that there are no guarantees when it comes to market performance or the performance of your employer in general. While in some cases your stock options may continue to grow in value while your grant price stays the same, the decision on whether you delay exercising until your expiration date is ultimately a conversation to have with your financial planner.
4. How will you use the profits from exercising your shares? It’s important to have a plan for the sudden influx of cash you’ll receive. After you set aside funds for the taxes you’ll owe on the sale of your shares, how will you use the money left over? Usually, it’s wise to have a specific goal in mind.
The last thing you want is for the money to “disappear” with odds and ends expenses when it could have made a large and focused impact on your financial life. Consider using the funds to boost your emergency savings, knock out a large portion of your debt, or contribute to a big financial goal (like education savings for your kids, or purchasing a home).
You want to make sure you’re getting the most value out of your employee stock options. Having a strategy in place can set you up for long-term success.
Stock Option Exercise in Practice
Let’s take a quick look at a stock option exercise example to give you an idea of what you might be able to expect, and to put some of these terms and definitions into practice:
Your company has offered you the right to purchase 2,000 stock options at $20.00/share. You have until January 1, 2025 to purchase.
You decide to sit on the stock option for a while until your company’s stock reaches $35.00/share on August 1, 2020, which is when you decide to exercise your options.
When you exercise your options, you’ll buy the 2,000 shares for $40,000 (the rate of $20.00/share that you were granted). Then, with a current price of $35.00/share you can sell them for $70,000. This leaves you with a $30,000 profit – not bad! However, you’ll have to set funds aside for short term capital gains taxes, which could be as much as 10-37% depending on your income tax bracket. This could dramatically impact the amount of profit you have leftover to reach your financial goals, which is why it’s so important to do your research before exercising. Finding a stock option calculator can give you a better idea of what to expect before you exercise.
Navigating Your Stock Options
Navigating your stock options isn’t always easy. In fact, many employees are so overwhelmed by the process that they either wait until the last minute to exercise, or they exercise without having a strategy for holding or selling their shares.
It’s important to walk into stock option decisions with your eyes wide open. Taxes around stock options can be complicated, and you don’t want to find yourself in a situation where you owe notably more than you had estimated when you exercised your options or sold them for a profit.
If you’re ready to take a closer look at your stock options, and how they impact your portfolio, reach out! We’d love to chat with you about what options are available to you, and how you want to leverage them to reach your goals.
