What should I do with my stock options?

In this article, we will explain the basics of stock options and how they work. We will also cover the difference between Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). Finally, you will learn about some factors to consider if you are trying to decide whether to exercise your options.

What are Stock Options?

Stock options are contracts that give investors the right (but not the obligation) to buy or sell a share at a specified price. Stock options give employees the right (but not the obligation) to purchase a certain number of the company’s shares at an agreed-upon price. These contracts are often referred to as equity compensation. This type of employee benefit is common in startups and other young companies.

How Do Employee Stock Options Work?

Employee stock options may seem like a great deal if you think your company will succeed in the future. But there are many details you need to know about these contracts. Below are some basic details you need to know about how employee stock options work.

Strike Price

The strike price is the amount you will pay for the shares when you exercise your options, meaning buying the shares granted to you. Regardless of market price fluctuations, the strike price does not change.

Vesting Schedule

Many employers have a vesting schedule that determines when you are allowed to exercise your options. If you leave your employer before your vesting period is complete, you may lose some or all of your stock options. Some companies offer a time-based vesting schedule and grant stock options gradually or all at once after a certain period. Some companies offer stock options based on performance.

Grant Date

The grant date is the date on which you are officially awarded your stock options. You should know this because you typically have a limited amount of time, known as the exercise window, to exercise your stock options.

Expiration Date

The expiration date is the date when the contract expires, and you can no longer exercise your stock options. Typically, the expiration date is up to 10 years from the grant date.

Blackout Dates

Some plans have blackout dates, which are periods during which your company can restrict exercising stock options. These dates often coincide with the end of the company’s fiscal year, the end of the calendar year, or dividend distribution schedules.

Incentive Stock Options vs. Non-Qualified Stock Options

The two main types of stock options are Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). The key difference lies in how they are taxed, with Incentive Stock Options receiving more favorable tax treatment.

When Taxes Are Applied

As long as you hold Incentive Stock Options for at least two years after the grant date and one year after the exercise date, they are not subject to taxes at the time of exercise. Taxes become due only when you sell your shares. However, you may be subject to the Alternative Minimum Tax (AMT) at the time of exercise.

Unlike Incentive Stock Options, Non-Qualified Stock Options are subject to taxes at the time of exercise. The compensation element, or the discount you receive from buying the stock, is taxed. To calculate the compensation element, subtract the exercise price from the market value of the stock.

Tax Rates

As long as you meet the holding requirements, Incentive Stock Options are taxed at long-term capital gains rates, which are lower than ordinary income rates. However, if you do not meet the holding requirements, your gains will be taxed at ordinary income rates in the year you sell.

The compensation element of Non-Qualified Stock Options is taxed when you exercise the options. Your employer must report the income on your W-2 form. The income is subject to federal, state, and local taxes, as well as payroll taxes. When you sell your shares, you will also be taxed on your gains. If you hold your shares for more than a year, you will be subject to lower long-term capital gains rates.

Who

Meets the Conditions

Incentive stock options are limited to employees and must be approved by the company’s board of directors. Incentive stock options come with additional restrictions. For example, incentive stock options cannot exceed $100,000 per year for any employee.

The rules for non-qualified stock options are less strict. Some non-employees, such as board members, contractors, and consultants, may qualify for non-qualified stock options.

Should I Exercise My Stock Options?

If you are wondering whether you should exercise your stock options, you need to consider several factors, including your financial situation and how you feel about your company’s future. Here are some things to keep in mind.

Current Stock Price

You only want to exercise your stock options if the options are “in the money,” which means the strike price is less than the market price. If the options are “out of the money,” you might pay less by buying the shares on the stock exchange instead of exercising your options.

Company Path

If you are an employee very early on, you may be granted stock options at a very low strike price per share. In this case, it might make sense to exercise them even though you risk losing your entire investment. You are putting a relatively small amount at stake, and the potential return is huge if the company succeeds.

The higher the strike price, the more important it is to have confidence in your company’s chances of success before exercising the options.

Your Tax Situation

If you are considering exercising stock options, it is essential to consult with a tax professional. If you have non-qualified stock options, you will face a tax risk for the current year on the deduction. With both incentive stock options and non-qualified stock options, you will pay taxes when you sell your shares. Delaying the exercise of incentive stock options could trigger alternative minimum tax (AMT) if your stock’s value increases significantly.

Liquidity Needs

With any investment decision, it is important to consider your immediate cash needs before investing. This is especially true if you are thinking about exercising stock options while your company is preparing for an initial public offering (IPO). Typically, you have a restriction on selling your employee shares for the first six months after your company goes public. Since stock prices often drop after this period ends, you will also want to give time for your shares to recover.

Conclusion

Employee stock options can be a valuable benefit when you join a company at an early stage, especially if you are one of the first employees. While the potential return is huge, there is also the risk of losing it all if the company fails.

If you are considering an offer that includes stock options, think about your other investments before exercising your options. A common rule is that a single investment should not make up more than 5% to 10% of your portfolio. Before exercising your options, look at your own financial needs, as well as the company’s chances of success.

Frequently Asked Questions (FAQs)

What should you do with your 401(k) plan and stock options when leaving the company?

Check your company’s 401(k) plan and stock option plan rules to see what options are available to you. Many 401(k) plans allow you to stay enrolled in the plan even if you are no longer employed by the company. Otherwise, you can roll over your 401(k) balance to a new employer’s plan or an individual retirement account (IRA). For stock options, you typically have a limited window to exercise vested options after leaving the company.

What is the benefit of stock options?

Employees often accept stock options instead of a higher salary because they give them the opportunity to earn a
Source: https://www.thebalancemoney.com/what-should-i-do-with-my-stock-options-2386299