Exploring Your Options
Earlier this year, I wrote a blog that stated your salary alone will not make you wealthy. Within that piece, I mentioned that stock options are becoming increasingly popular as a form of compensation given by employers.
While these can be great opportunities to gain equity in your company, its important to distinguish the differences between the types of options, how they work, and how you are ultimately taxed.
Incentive Stock Options (ISOs) – ISOs give you, the employee, the right to buy shares of your company’s stock, typically at a discount, referred to as the ‘strike price’. There are three stages with ISOs: your employer grants you ISOs, you exercise the ISOs once they become vested, and ultimately you sell them. Important to note that you will not be taxed on the ISOs until you sell the shares.
In order to qualify for more favorable tax treatment, it is often recommended that you hold the shares for one year and one day from when you exercised and 2 years from the grant date. This will usually result in a lower tax bill for when you sell the ISOs, those gains will be taxed at the long-term capital gains rate, rather than your ordinary income rate. Typically, you must exercise ISOs within 10 years from the grant date or they expire.
There are a few complicated topics when it comes to ISOs. Some employers allow you to early exercise ISOs (before they become fully vested) to help minimize taxes owed. This is referred to as an 83(b) election. Additionally, if your profit is large enough when you exercise your ISOs, this can trigger alternative minimum tax (AMT). Please consult your financial professional or CPA for further information on those topics.
Non-Qualified Stock Options (NSOs) – Similar to ISOs, NSOs give you the right to buy shares of your company’s stock at a pre-set price. Company’s may offer NSOs as an alternative to compensation and give employees a reason to stay with their company. One of the major differences, compared to ISOs, is when you are taxed.
Unlike ISOs, NSOs are taxed as ordinary income in the year in which you exercise them. The tax liability will be determined using the difference between the grant price and the price of the stock when you exercise the option. An important note is that AMT does not apply for NSOs. When you exercise, you can sell them immediately or hold onto them.
Restricted Stock Units (RSUs) – When you think of RSUs, think of additional income. Once the RSUs vest, they are considered income, which would be the market value of those shares at vesting. Typically, your company will withhold a portion of the shares to pay the taxes. Like the options outlined above, companies will grant RSUs in order to retain employees and give them an incentive to perform well so the company’s value increases.
Should you hold onto these RSUs after they vest, any gain (or loss) is taxed as a capital gain (or loss).
If you have been granted stock options with your company, it’s important to understand the types of options, grant date/price and what the current value of your company is. Also, it’s important to keep in mind your long-term goals and ensure that you consider all your options to capitalize on this opportunity and minimize your risk as much as possible.
Should you have questions related to your specific situation, reach out to your financial advisor or consult a CPA.
- Kyle
Disclosure: This material is for general information only and is not intended to provide specific advice or recommendations for any individual.