Non-qualified stock options are a benefit often provided to employees as part of their compensation package. If you’ve received a grant, there may be a nice profit if your employer’s stock increases in price. This, of course, is not guaranteed. There are many moving parts to a non-qualified stock option grant. To recognize the most meaningful value, you need to understand non-qualified stock options and how they can impact your tax situation.
What is a stock option?
Stock options are a form of compensation used to attract talent, reduce turnover, and incentivize employees. There are three types of stock options, restricted stock units (RSUs), which you can learn more about in our post, Have a plan to manage your Restricted Stock Units (RSUs) to Improve your long-term financial success, incentive stock options (ISOs), which will be a future blog post, and, non-qualified stock options.
Non-qualified stock options
There are 4 critical pieces of information about non-qualified stock options (known as NQOs, NSOs, or NSQOs) you need to be aware of:
- GRANT DATE: The initial date that the stock options are given to you.
- EXERCISE PRICE: Also called the strike price or grant price, this is the price per share you’ll pay for the stock. The price is determined by the fair market value (FMV), or a discount on the FMV, on the grant date.
- VESTING SCHEDULE: This is the specific time when you’ll be allowed to exercise your options and spells out how many shares can be exercised.
- GRANT EXPIRATION DATE: Non-qualified stock options, like milk, have an expiration date. If you have not exercised the stock options by the expiration date, you lose them. If you quit or retire, you’ll have a specific amount of time to exercise your vested NQOs. If you don’t exercise, you’ll lose them. All non-vested options will be lost on all but rare occasions.
Your employer, LMNOP, has granted you 10,000 shares on December 15, 2020 (grant date). The shares have a 4-year vesting schedule, which means on December 15, 2021, 2022, 2023, and 2024, you will be able to exercise 25%, or 2,500 shares, on or after each date. The grant expiration is in 10 years, December 15, 2030. The exercise price is the market value of LMNOP on December 15, 2020, $10 per share.
Receiving the grant is a non-taxable event. You don’t owe any tax, nor are you required to report anything. This simply means your employer has given you the right to buy a specific number of shares at a set price in the future.
Non-qualified stock options vest
It’s December 15, 2021, and your first non-qualified stock options have vested. You now have the right to exercise (or buy) 2,500 shares of LMNOP. You’re not required to, but you can exercise on any date after your NQOs vest up until the grant expiration. When your shares vest, there are still no taxes due, nor do you need to report anything.
Now is the point when NQOs start to get complicated. You have decisions to make, and those decisions have financial repercussions. The first question is, when should you exercise the options?
Easiest Decision: If the stock price is less than your exercise price, your option’s value is zero and is considered underwater.
For example, 2,500 shares of LMNOP have vested, and the current stock market price is $5.00 per share. Remember, your exercise price is $10 per share. The shares are underwater, and you’re not going to buy them for $10 per share when their value is currently $5 per share.
IN THE MONEY: If the stock price is above the exercise price, the option is in the money.
For example, if your 2,500 shares of LMNOP are $20 per share and your exercise price is $10 per share, the option is in the money.
Exercising your non-qualified stock options
Taxation begins when you exercise an NQO. The difference between market value and exercise price, called the bargain element, is considered ordinary income. That bargain element is taxed as compensation subject to federal income tax, Social Security tax, and Medicare tax withholding. It will be reported on the W-2 for the year of exercise.
Continuing with our “In the money” example, let’s say your 2,500 shares of LMNOP are $20 per share, and your exercise price is $10 per share. If you choose to exercise your 2,500 shares, you’ll have a bargain element of…
(2,500 shares x $20 current market value) – (2,500 shares x $10 excersise price) = $25,000, which will be taxed as earned income.
As you can see, the more significant the difference between the exercise price and the shares’ current value, the higher the tax bill. Paying that tax bill can be challenging. Thankfully, most companies allow a cashless exercise in which you can sell enough shares back to your employer to cover the tax bill.
Voilà now you own stock
After you exercise your non-qualified stock option, the next taxable event occurs when you decide to sell the shares that you’ve exercised. The cost basis of the stock is the exercise price plus any brokerage fees and commissions. When the stock is sold, you’ll report a capital gain (or loss) for the difference between the gross proceeds from selling the stock minus the stock’s adjusted cost basis. Once exercised, you have three options:
- Sell Immediately: If you sell at the same time you exercise your newly vested shares, you will not have any capital gains (or losses) and, therefore, will not pay additional tax.
- Sell less than 1 year: If you exercise your shares and hold them for less than one year, and there you’ll be subject to short-term capital gains, which are taxed at higher ordinary income tax rates.
- Sell later than 1 year: If you sell your shares at least a year after exercised, they will be classified as long-term gains, and you’ll be subject to the long-term capital gains tax rate, which is usually lower than the short-term capital gains tax rate.
Keep in mind there is no time limit. The shares are now yours, and you can hold the stock until the cows come home. When you decide to sell is based on your needs, tax considerations, and of course, the price of the stock. Over time the value of the shares will fluctuate with the markets. There is investment risk.
The best answer is one that is customized to you and your needs. A detailed financial plan and detailed liquidation strategy can help determine the best course of action.
Managing Your Non-qualified Stock Options
There are three often competing goals of stock options:
- Minimize tax liability: If you’re receiving NQO grants, you’re probably a high earner and, therefore, in a higher tax bracket. Exercising your options could create some less than ideal tax situations.
- Maximize value: On the other hand, some decisions have to be made to maximize the options’ value. You’re at the mercy of the stock price, economy, financial outlook of your employer, and of course, the expiration date of the grant. You don’t want to have worthless options.
- Concentration risk: This risk occurs when you have a large amount of your net worth and income tied to your employer. Typically, you shouldn’t have more than 10% in your employer’s stock. Large grants make this target difficult to achieve, but having a financial plan and a liquidation strategy can help.
A stock option strategy must be a part of your comprehensive financial plan. Not taking the time to properly plan today may prevent you from achieving your stock option goals. Providing specific do this, don’t do that advice for NQOs is pointless. First, every company and stock price history is different. Second, every individual has various financial circumstances. It’s like a Rubik’s cube of possibilities. There are several strategies, some quite complicated, available to you when exercising your options.
The key to non-qualified stock options is to know the rules – vesting, expiration, and taxation. Then you have to integrate them into an overall comprehensive financial plan. Proper planning increases the chances that you will receive the most significant value with the lowest taxes.
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