For those lucky enough to have an employee stock option plan – the rewards can be quite substantial. If managed properly, those assets could fund many of your financial goals (i.e. retirement, a dream wedding, new home, paying for your kids’ college). This is one of the main reasons plans like these have been used, for years, to attract and retain top level talent. While those types of plans are commonly offered by tech companies like Apple, Google and Tesla, they are also provided by a number of other employers.
Of course, in situations like those where much is given, much is also expected. Stock option plans are often misunderstood and choices are often made that leave people paying substantially more taxes on this employee benefit than is absolutely necessary. Small mistakes could result in hundreds of thousands of dollars in extra taxes due, in some cases. Understanding how your stock options work, and the taxation and impact on your personal income, is an important part of maximizing the value of your company stock options. Keep more of this valuable asset that you have worked hard to earn.
What Exactly is an Employee Stock Option?
An employee stock option is basically a contract, from your employer, allowing you to buy a certain number of shares of company stock, at a specific price, over some specific time period. Non-Qualified Stock Options (NSO) and Incentive Stock Options (ISO) are the most common forms of company stock options.
There are two major differences between NSOs and ISOs. First, NSOs are typically offered to a wider range of people. This could include non-executive employees, consultants and even outside directors. However, ISOs are more likely to be reserved for employees the company wishes to incentivize in some way. Think high-level executives. Secondly, ISOs are given preferential tax treatment by the Internal Revenue Service (IRS). NSOs do not receive any special tax treatment. Providing stock options and additional tax savings to only high-level executives, while excluding the rank-and-file workers, should come as no surprise.
NSO and ISO plans are confusing, complex and could lead to people making tough decisions without really understanding them. Not all plans are the same nor are they created equal. There are long lists of rules and regulations that must be followed according to your employer agreement, as well as IRS rules.
Stock Options Terms You Need to Know.
- GRANT DATE: Most of the time you are not granted full ownership of actual stock right off the bat. Grant date is the initial date that the options are granted to you. This is important because the amount you will have to pay in taxes could be based on how close or far you are from this date.
- VESTING SCHEDULE: Vesting is when you actually take full control of the options. Most stock option plans include what is called a vesting schedule. The vesting schedule will begin the day the options are granted, list the specific time when you will be able to exercise your options and how many shares can be exercised. To give an example, if you are lucky enough to be granted 5,000 shares on the grant date, but 20% vest each year, you would be able to sell 1,000 shares, one year, from the grant date. The following year another 1,000 shares would become available and so on.
- GRANT EXPIRATION DATE: At some point, the options will expire if you do nothing with them. This day is called the expiration date and once the expiration date has passed, the employer is no longer on the hook to honor the stock options agreement. Know your expiration dates and don’t miss them. Mark your calendar and set a reminder. Don’t wait until the last minute, especially if your company has blackout dates for selling shares. You could end up out of luck, and a lot poorer, if your stock options are allowed to expire.
- EXERCISE PRICE: This has nothing to do with time spent on a treadmill or in some type of bootcamp workout class. There is a specific price listed when an employee stock option is granted. Known as the exercise price, this is what you would pay to buy your options. The gain from your purchase is determined by the gap between the value of the stock at the time of exercise and the exercise price. Known as the “bargain element”, this gap is considered compensation and taxed at ordinary income tax rates. This may also trigger the dreaded Alternative Minimum Tax (AMT) – which is why many people seek out the expertise of a Certified Financial Planner™ and CPA to help them minimize the sting of taxes on their stock options.
Taxation of stock options will vary depending on the type of options owned, held duration and the aforementioned bargain element. The IRS has a strict set of rules that need to be carefully followed to avoid paying the maximum amount of taxes. Selling one day too early can cost you dearly.
Taxation for non-qualified stock options (NSO)
- Granting of stocks is not a taxable event
- Taxation begins at the time of exercise. The bargain element is taxed at ordinary income tax rates because it is considered part of your compensation. For example, if you are lucky enough to be granted 1,000 shares of stock, at an exercise price of $150 per share, and the current market value is $300 per share at the time of exercise, you will have a bargain element of $150,000 (1,000 x $150). That assumes all of the shares exercised were fully vested.
- Another taxable event occurs when you eventually sell the shares that you have previously exercised. Selling shares immediately, or less than one year of exercising the shares, will result in the transaction being subject to short-term capital gains (or loss) rates. That would be a costly decision for those with substantial options because those shares would be subject to taxation at the ordinary income tax rates. Individuals who are patient and sell shares at least a year after exercised, they will be subject to long-term capital gains taxation, which is generally less costly than short-term rates and results in less taxes being owed.
Taxation for incentive stock options (ISO)
- Again, granting of stocks is not a taxable event
- Exercise does not trigger a taxable event. The one exception is the bargain element of an ISO. It may cause you to be subject to the Alternative Minimum Tax.
- Your first taxable event doesn’t occur until you sell shares. If you sell immediately after the stock options are exercised, the bargain element is taxed at the tax rates for ordinary income. Currently, the top rate is 37% for federal taxes, plus your state’s taxes, which is 13.3% for California.
- A few rules need to be followed in order to have the gains on your options be treated as long-term. The employer stock options must be held for 12 months after exercise and should not be sold within two years after the original grant date. To put this in real terms, assume stock options are granted on August 18, 2018 (and immediately 100% vested). The employee exercises the options, one year later, on August 18, 2019. To benefit from the likely lower long-term capital gains rates, that employee shouldn’t sell the shares before August 18, 2020. Patience pays off in the form of owing less in taxes.
Tips to Maximize Your Employer Stock Options
While minimizing taxes are a big part of maximizing the value of your employer stock options, it shouldn’t be the only concern. I previously wrote about “How Risky are Those Company Stock Options”. Having large amount of your net worth tied to a single stock can be quite risky. Instead, pay some taxes now to help diversify and reduce the overall risk of your investment portfolio.
Typically, an advisor would never suggest owning more than 10-20% in any single stock. While large stock option grants may make this rule of thumb impossible to follow, great problem to have, you can still work toward this number over time. Consider selling enough shares, each year, to max out your retirement account contributions to a 401(k) and maybe your spouse’s retirement plan as well.
Consider dollar-cost averaging out of your company stock over time. I often recommend that clients sell a specified percentage of their stock options each year. For my best-paid executive clients, they tend to get more grants year-after-year. Even after selling, their net account balance in company stock have tended to increase over time. The important thing is their overall investment allocation risk was lowered by funding retirement and other investment accounts. Additionally, a date is set each year to sell a percentage of their stock options (e.g. 10%) regardless of whether the stock is up or down that day. For larger amounts, we may break this up over a few weeks to avoid a bad day in the market and add a little piece of mind. Some tech stocks can be quite volatile. The point is to sell some each year so you don’t end up the victim of a horror story, who had all her or his eggs in one basket, which somehow got crushed.
Funding your Financial Plan with Stock Options
It has been my experience, working with people who have stock options via their employer, that this valuable asset is often ignored. In some cases, doing nothing doesn’t really cause any short-term problems. Often, it even avoids having to pay taxes now. Remember that doing nothing is a choice, which can have negative consequences. Not taking the time to properly plan today may create a massive tax time bomb down the road.
Procrastination is common when it comes to financial planning. Waiting until the last minute, or the day of expiration can lead to uninformed and rash financial decisions. Even worse, some people completely ignore important dates regarding their stock options. In doing so, they let them expire, worthless, or make poor choices that lead to tax bills much larger than they need to be.
I’ve found that making decisions about your employer stock options, as part of a comprehensive financial plan, can help make the process a bit less stressful. As previously mentioned, my clients and I normally plan to sell a specific portion of the stock options each year (assuming they have enough in the long-term gains territory). If you are selling some of the shares to fund your other financial goals, it makes it much easier to not freak out when the stock jumps up in value. Also, having other assets can make staying put easier when the stock takes a dive in value.
You can potentially help offset some of the taxes you will be paying along the way as you exercise/sell the options. Using some of the proceeds to max out your 401(k) contribution can help. This may also allow you to capture more employer matching on your 401(k). Many of my clients also use the money to max out their spouse’s retirement accounts.
Still, others have used the money to purchase a home. Spreading out the sale of stock options into more than one tax year greatly decreases the tax burden versus pulling it all out at once. To be fair most of my clients with large amounts of stock options are in places with expensive real estate like San Francisco, Seattle and Los Angeles. Pulling together a $500,000 down payment is a much different conversation than needing one for $25,000. The bigger the numbers the more likely you are to find yourselves in the top tax brackets- facing larger tax liabilities. Good problem to have, also a good problem to try and minimize.
Stock options can useful in a variety of ways. Be proactive and work with your Certified Financial Planner and CPA to develop a strategy that will allow your valuable stock options to fund your various financial goals (e.g. retirement, sending your kids to college, paying down debt or perhaps buying a vacation home). By planning ahead, you can strategically lower your overall investment risk, but also pay the least amount of taxes possible over time. I think we can all agree no one likes a big tax bill.
I am not offering specific investment advice here and by no means am I telling you to buy or sell any specific stock. All investment decisions should be made based on your financial plan, which can make difficult decisions easier to comprehend and implement.