Employee Stock Options Explained

Matt Johnston is a senior director in Sophisticated Planning Strategies at Northwestern Mutual.

Maybe you’ve paid your dues for years and are finally getting a promotion. Or perhaps you’re being recruited by a tech startup that wants you to get in early.

In situations like these, a company may try to woo you with a compensation package that includes stock options. These are used to tie your total pay to the company’s performance so that if the company does well, you do well. While stock options won’t pad your paycheck right away, they can help grow your wealth in the long run.

As you work through the details of an employee stock option plan, it’s easy to get overwhelmed by all of the jargon. We’ve collected eight of the most common terms you might come across and decoded them, so you’ll know exactly what you’re being offered.

1. Stock options

Let’s start, naturally, with stock options themselves. If you’re receiving stock options, your employer is offering you the right to purchase shares in the company at a preset price.

Stock options come in two main flavors: nonqualified stock options and incentive stock options, both of which we’ll get into later. The main difference between these two is how they are treated when it comes time to pay taxes.

2. Vesting

Vesting is the amount of time you need to be employed before you can take advantage of your stock options. It works in a way that’s similar to vesting in a retirement plan. By making you wait, the employer is enticing you to stick with the company. Usually, a company will have a vesting schedule for your options.

For example, they may offer you a package that vests over four years with a one-year cliff. This means you aren’t entitled to any options until you’ve worked for the company for at least one year. Here’s how this example would work:

• At your one-year anniversary, you’ll be 25 percent vested in your total options package. You continue to gain a small amount each month.
• At your second work anniversary, you’ll be 50 percent vested. If you leave now, you have the right to purchase only half of your total employee stock options package.
• At your third work anniversary, you’ll be 75 percent vested.
• At your fourth work anniversary, you’ll be 100 percent vested.

Companies choose to set different schedules and rules. It’s important to be sure you understand what happens to your options if you leave before you’re fully vested.

3. Exercise stock options

If you exercise your stock options, that means you have decided to pay for them and then sell them. You’re purchasing shares at the price set in your contract (sometimes called the “exercise price” or “strike price”). You can exercise only as many options as you are vested in. Once you are vested, you usually have a specified amount of time to purchase the shares before your options expire.

Some people choose to exercise their options as soon as they are eligible. Others wait until the share price is at a level at which they would be willing to sell. Some people refer to this step as “exercise and sell.” There is no right or wrong decision for when to exercise. It depends on your own circumstances and tax situation because exercising and selling may trigger taxes. Your financial advisor and a tax advisor can help you plan out the best strategy.

4. Fair market value

This is the amount of money your stock would be worth if it were sold on the open market on the day that you exercised your stock options. The spread is the difference between your strike price and the fair market value (also known as the “bargain element”) and clues you in on how much you’d stand to gain if you sold your options. It also helps you calculate the potential tax impact, depending on whether your options are categorized as nonqualified or incentive stock options.

5. Nonqualified stock option

Nonqualified stock options, sometimes abbreviated as NSOs or NQOs, do not qualify for the same tax advantages that incentive stock options get. So, when you exercise a nonqualified stock option, you will pay taxes two times. You will first pay ordinary income tax on the difference between the fair market value and the exercise price of the stock. That’s because this difference is considered compensation by the IRS (even if you haven’t actually made any money by selling the shares).

Then, when you ultimately sell the stock, you may owe capital gains tax (assuming you sell at a gain). The rate will be dependent upon how long you’ve held the stock.

• If you held the stock for a year or less, you’ll pay taxes at the short-term capital gains rate.
• If you held it for more than a year, you’ll pay taxes at the long-term capital gains rate.
• If you sell at a loss, you can record it as a capital loss for tax purposes.

6. Incentive stock option

Incentive stock options (ISOs) have a more favorable tax treatment. When you exercise ISOs, you do not pay ordinary income taxes on the difference between the fair market value and the exercise price, as you do with NSOs. Instead, you pay only capital gains taxes (or record a capital loss) when you ultimately sell your stock.

There is a limit, however, to the total value of ISOs that can become exercisable in a given year and still retain this tax benefit. It’s known as the $100,000 limit. That $100,000 refers to the fair market value of your options at the time they were granted, but the tax rule itself takes your vesting schedule into consideration.

So, for example, if your stock has a total fair market value of $120,000 but vests over four years, that means each year the exercisable amount is only $30,000—you’d still fall within the limits of the rule. If for some reason your exercisable amount exceeds $100,000 in a given year, anything above the limit would be treated as NSOs tax-wise.

ISOs also have holding periods you have to meet before you can sell them. You must hold them for at least two years from the grant date and at least one year after exercising them. Otherwise, you may lose out on their tax benefits.

You can work with a tax accountant or financial advisor for help with tax implications. They can explain the alternative minimum tax (AMT), which ensures a minimum amount of tax is paid by people above an income threshold. They could also tell you about a cashless exercise, in which you exercise your stock options with the help of a short-term loan.

7. Restricted stock award

Employers can provide even more types of equity compensation. For example, a restricted stock award is a predetermined amount of stock that belongs to an employee once certain restrictions have been met. These restrictions are usually related to a vesting period, employee or company performance or some combination thereof.

Restricted stock is different from stock options in that there is usually no purchasing involved. Regular employee stock options grant you the right to purchase stock at an exercise price, but restricted stock is awarded to you outright after the restrictions are lifted. (Some companies may require you to purchase a restricted-stock grant from them, but this is less common.) Once your award vests, you can choose to receive it either in shares or in the shares’ cash equivalent.

Because you typically haven’t paid money upfront to buy your shares, your restricted stock award will almost always represent a profit to you. You will, however, owe taxes. You will have to pay ordinary income taxes on the fair market value of the stock in the year that it vests, and then you’ll have to pay capital gains tax on anything above that fair market value when you eventually sell.

8. Employee stock purchase plan

An employee stock purchase plan (ESPP) is another form of equity compensation that some companies offer their employees, with the intention of making it easier for workers to purchase company stock (often at up to a 15% discounted price). ESPPs allow employees to use after-tax payroll deductions to buy the shares; the employer then holds the contributions in an account until a specified purchase date that typically comes around every six months.

Pros and cons of employee stock options

As you think about stock options, here are some of the major considerations. You can talk them through with a financial advisor and tax professional.

Pros

• If the company does well, stocks can be worth much more than cash compensation. In the long run, you could have a powerful financial tool available.
• You won’t owe ordinary income taxes on the exercise of incentive stock options, allowing you to receive a benefit from you employee that will ultimately be taxed at lower long-term capital gain rates when you sell the stock.

Cons

• When you sell the stock, you may owe capital gains tax.
• If you leave the employer, you typically give up the stock options with no compensation.

If you have more questions about your compensation package, your Northwestern Mutual financial advisor is a great place to start.

This publication is not intended as legal or tax advice. Taxpayers should seek advice based on their particular circumstances from an independent tax advisor.

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