It’s always great to have options. But when it comes to your employee stock options, weighing so many variables can make it difficult to determine the most opportune time to exercise and reap your financial reward.
What are stock options?
There are two types of stock options: exchange traded options and employee stock options. Here we focus on the latter.
Employee stock options are a type of stock-awarding scheme that gives you the right to buy a certain number of company shares at a certain price when exercised. Vesting refers to the point in time at which you actually acquire ownership of your options and can exercise them (purchase of company shares).
Stock options help align your interests with those of your employer. The higher your company’s share price goes, the more your options are worth and provide an added incentive to grow your business.
This is how employee stock options work
Everything starts on the day it is granted, i.e. the day on which you receive a stock option agreement from your employer. The contract determines how many shares of the company you can buy at a certain price (the exercise price, also known as the exercise price) after waiting until a certain point in time (the vesting date). It also sets the expiration date so you know the time frame over which to exercise your options. Your stock options give you the right to exercise when and when you want, but you are never required to do so.
If you choose to exercise your stock options, you can keep or sell your company shares.
Types of employee stock options
There are two main types of employee stock options that differ in a few ways.
Incentive stock options or ISOs. Also known as statutory or qualified stock options, Incentive stock options can benefit from tax benefits. If exercised shares are held for a certain period of time, they will tick the “Qualified Disposal” box and will be taxed on the sale of company shares, only to Capital Gains Rates. ISOs are only issued to employees.
Not legal options or NSOs. Also called non-qualified stock options, are not legal options when exercised. taxed Income tax rates and again, when shares are sold – all accrued profits are taxed at capital gains tax rates. NSOs can be granted to external service providers, consultants or consultants.
Knowing what type of options you have and understanding the different tax implications of each option is critical as this information can help you decide when to exercise your stock options.
When should stock options be exercised?
Provided that you remain employed by the company, you can exercise your options at any point in time after the vesting date until the expiration date – this is usually up to 10 years. When you leave your employer, check the fine print on your option contract to see what length of time you need to exercise; this is usually referred to as the “exercise period after termination”.
There are many considerations within that 10 year window in determining the ideal time to exercise your stock options. Here are four to start with.
Whether your options have value
It only makes sense to exercise your options when they have value. If so, they are said to be “in the money”. This happens when the exercise price (or exercise price) of your stock options is lower than the market price of your publicly traded shares in your company. In this case, you can exercise your options and acquire shares in the company at the lower exercise price. Then you could turn around and sell those stocks on the stock exchange and pocket the difference – known as the “bargain” item.
If you believe in your company’s future prospects, stick with your options. If your company’s share price rises, the value of your options will continue to grow without any tax consequences. This optionality or flexibility for a longer period of time adds even more value to your options. Of course, there is also the possibility that the market price never exceeds the exercise price of your options. In this case, your options could expire worthless.
While you wait, don’t forget to keep an eye on the expiration date. Unfortunately, valuable options can be wasted if they are not exercised in a timely manner.
Whether your company is public or private
It also makes a difference whether your company is publicly traded or privately owned. Private company stocks are not publicly traded, so you will have to pay out of pocket to exercise and finance the purchase (rather than being able to sell stocks and cover your expenses). And you run the risk of holding illiquid stocks that can take a long time to make initial public offering or any other liquidity event that you can withdraw.
If your company is private and is going public, it might be a good time to consider exercising your incentive stock options. ISOs are subject to a holding period of one year after exercise – and two years after grant – in order to qualify for tax breaks. As soon as a company applies for an IPO, it usually takes several months for the actual listing to take place. Immediately after listing on the stock exchange, employees of the company are usually subject to a blocking period during which they are excluded from selling shares for up to six months after listing on the stock exchange. Hopefully, if you are exercising your options at the time of filing, the combined period from filing to the post-lock period will coincide with the time when you can also qualify for preferential tax treatment.
Whether it suits your financial situation
With many financial decisions, the best time to do something is when it works for you and your individual goals. If your income covers all of your expenses, you may not need additional income from exercising your options and selling stocks. Or maybe you have Deferred compensation enter for a few years and defer exercising your options until later. These scenarios mean that you can wait to exercise, which could potentially give the market price of your company stocks more time to rise.
However, you may need an infusion of cash for another purpose – to start a business, fund an education, or buy a home. Depending on the other aspects of your financial situation, exercising your options and selling stocks can help you fund another, more compelling goal or investment opportunity.
Another thing to consider is your entire financial portfolio and its asset allocation. If you are overly exposed in your company shares, you may want to exercise your options and sell your company shares using that proceeds to Diversify your portfolio.
Whether it makes sense for tax purposes
Depending on the type of employee stock options you own, you will need to consider different tax treatments, such as: B. normal income tax, capital gains tax and alternative minimum tax. In addition to matching your financial goals and income needs, you should consider the tax implications of exercising your options and holding company shares prior to the sale.
For NSOs or ISOs sold without a qualifying disposition, the bargain element of your stock options is typically taxed at income tax rates in the year of exercise. If your annual income already puts you in a high income tax bracket, or if additional income from stock options could push you into a higher income tax bracket, you may want to defer exercising your options or spread the exercise over several – potentially lower tax – years.
There is no tax on exercise for ISOs with a qualified disposal – you will not be taxed until you sell your company shares. If you hold company shares for favorable tax treatment, the bargain element could trigger AMT.
Should you train early?
Your company may allow you to exercise employee stock options early before they vest. This means that you would pay to purchase company shares but still be subject to the original grant schedule before the shares are officially yours and can be sold.
It may seem absurd to pay for something before it’s yours. And exercising early carries an additional risk: the stocks may never reach the desired value.
So why would anyone consider exercising early? Because it starts the hold timer for ISOs to qualify for favorable tax treatment.
Moving early could help you avoid taxes. If you can buy company shares when the exercise price is close to the market price, you can file an 83 (b) election to request that the IRS recognize your income at that point – before the shares continue to appreciate in value. Since you’ve made little to no income, you’ll pay less tax than if taxes were levied after stocks appreciated over time. Note, however, that you must file the 83 (b) election within 30 days of exercising.
“Still unsure when to exercise? It may be time to talk to one Financial advisor