Employee stock options can be a valuable way to take advantage of your company’s growth and enhance your financial security. However, it’s important to understand the fine print. Each opportunity comes with its own set of rules for how you receive, manage, and maximize it. Not fully understanding your stock options can negatively impact your financial success.
In order to guard yourself against leaving money on the table, unsavory tax surprises, and poor stock management, you need a plan. Keep reading to get the information and strategies you need to make the most of NQSOs, ISOs, and restricted stock options.
Non-Qualified Stock Options (NQSOs)
Non-Qualified Stock Options (NQSOs) are by far the most common stock incentive offering. They give you the right to buy a certain number of company shares, at a specified price (the exercise price) during a window of time (typically 10 years). The “non-qualified” in its name doesn’t mean that it’s exclusive—on the contrary, NQSOs can be given to all levels of individuals including employees, directors, contracts, and consultants. They are considered “non-qualified” because this type of stock option isn’t eligible for special tax consideration under the IRS code.
Here’s how NQSOs work. Once NQSOs vest, you can choose to exercise and purchase the shares, but you are not required to do so. If you choose to exercise the options, taxes are based on the spread, meaning the difference between the grant price and the fair market value of the stock at the time of exercise. The difference will be considered compensation income, which means your employer will also withhold income tax, Medicare tax, and Social Security, and this compensation will be declared on that year’s W-2.
When you subsequently sell the shares, any further increase will be taxed as either a short or long-term capital gain, depending on how long you’ve held onto the shares. You’ll report any earnings on your IRS 1040 tax return, on Form 8949, Schedule D.
Incentive Stock Options (ISOs)
Like NQSOs, Incentive Stock Options (ISOs) are a form of equity compensation that may be offered to you by an employer. Unlike NQSOs, however, ISOs qualify for a special kind of tax treatment, meaning they aren’t subject to Medicare, Social Security, or withholding taxes, though they must meet very rigid tax code criteria.
ISOs differ from NQSOs in a number of other notable ways including:
- There’s a $100,000 limit on an ISO’s vested aggregate value in a calendar year.
- While NQSOs can be given to a number of different kinds of people affiliated with a company, ISOs can only be given to employees, not consultants or contractors.
- In order to get the full tax benefits, you’re required to exercise your ISOs within 90 days of leaving the company.
Keep in mind that you must hold your shares for at least two years from when they were granted and at least one year from when they were exercised in order to take advantage of the long-term capital gains tax after exercising your ISOs. If you hold onto them for any shorter length of time, anything you appreciate will be taxed at the standard income tax rate, which is generally much higher than the long-term capital gains tax rate.
Conversely, if you hold onto your ISOs beyond the calendar year in which they were exercised and have gains, you will be subject to the alternative minimum tax. In and of itself, that’s a financial nuisance, but not a problem. However, in the hypothetical but very real scenario that your company’s stock price takes a dive, you’ll be left to pay a high amount of tax on income that has completely disappeared.
One other important consideration for both NQSOs and ISOs: whether it’s advantageous to make a Section 83(b) election, which allows you to be taxed on the value of shares when they’re granted to you, rather than when they are vested. Consulting a financial advisor is a good idea when making this choice—between costs, taxes, requirements, and deadlines, it can be a very complicated endeavor.
Some companies aren’t able to give stock options and choose to give restricted stock units (RSUs) instead. RSUs are a common form of employee compensation that grants non-transferable shares, which usually come with conditions and restrictions regarding the timing of sales.
RSUs maintain their value of vesting regardless of the performance of the stock itself. It could have increased, decreased, or remained the same since the grant date and the restricted stock would have the same value. That’s in stark contrast to NQSOs and ISOs, both of which depend on how much your company’s stock price differs from the price set on the date you received it.
From the IRS’s perspective, restricted stock is considered to be a supplemental wage, which means it follows the same tax and reporting requirements as NQSOs do. Restricted stock may be particularly attractive to people who have a lower risk tolerance, but to receive that surefire value, you must remain employed until your shares vest. Oftentimes, unvested restricted stock is forfeited immediately once employment is terminated.
Need Help Making Sense of Your Stock Options? We Can Help
If you’d like to be sure you understand the ins and outs of your stock options, consider partnering with a professional to develop the right strategy for you. If you think you may benefit from a conversation about your equity compensation, contact Lane Hipple Wealth Management Group at our Moorestown, NJ office by calling 856-638-1855, emailing firstname.lastname@example.org, or to schedule a complimentary discovery call, use this link to find a convenient time.
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