Equity Compensation

Understanding Your Stock Options: A Guide to Incentive and Non-Qualified Stock Options

Michael Kelly, CFA, CFP®

What are Stock Options?

Stock Options are a valuable form of equity compensation offered by certain startups and in executive compensation packages. Stock Options give employees the right to purchase a specified number of company shares at a predetermined price (the exercise or strike price) within a designated time frame. The goal of offering stock options is for employees to be more invested in the growth of their company and to have the potential to benefit from that growth over time. 

How do Stock Options work?

Stock Options typically come with a vesting schedule, similar to RSUs, where employees must remain with the company for a specified period before exercising their options. Meeting the requirements to exercise your options is known as “vesting”. Once vested, employees can choose to exercise their options and buy shares of the company at the predetermined price. The difference between the exercise price and the market value at the time of exercise is known as the spread.

How are Stock Options Taxed?

Many employees come to us with questions about employee stock option plan taxes. To understand the taxes of your stock options it’s important to understand that there are two types of stock options, each with their own unique tax treatment. The two types are Non-Qualified Stock Options (NSOs) and Incentive Stock Options (ISOs). Tax planning for your stock options relies on understanding these differences. Let's take a look at Incentive Stock Options (ISOs) vs. Non-Qualified Stock Options (NSOs):

ISO Tax Treatment

ISOs come with special tax treatment, provided certain conditions are met. The gains from ISOs may qualify for preferential long-term capital gains tax rates. ISOs must be held for one year from their exercise date and at least two years from their grant date to have these advantages (this would be called a “qualifying disposition”). One of the key tax planning opportunities for Incentive Stock Options is AMT Planning. While ISOs don’t increase your income taxes when exercised, the difference between the exercise price and the market price (also called the spread or the bargain element) is subject to Alternative Minimum Tax. The AMT is a separate calculation that comes into play with certain types of income like the exercise of Incentive Stock Options. Any time you consider exercising stock options it’s important to update your tax plan and to consider what cash you have on hand to manage your income, expenses, and tax bills.

NSO Tax Treatment

Non-Qualified Stock Options (NSOs) do not have the same tax advantages as ISOs. Since they don’t have these advantages NSOs are taxed much more simply. The spread at the time of exercise is considered ordinary income, subject to regular income tax rates. Additionally, if you hold shares of the company after exercise you will be subject to Short-Term Capital Gains or Long-Term Capital Gains on your NSOs depending on how long you hold them before selling. NSOs are more flexible in terms of eligibility and can be offered to a broader range of employees.

How Can I Plan for My Stock Options?

Financial Planning for Stock Options can be a valuable part of building wealth. We refer to planning for Stock Options as Strategic Planning because it means considering your current situation as well as your future goals and it requires looking at multiple areas of your financial life (taxes, income, expenses, personal goals etc.) Factors such as the timing of exercise, market conditions, and tax implications should be carefully considered. Your planning opportunities vary somewhat between Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs) so let’s review them separately:

Financial Planning for ISOs
Given their potential tax advantages ISOs deserve careful planning. Here are a few points to consider as you make your plans:

  • Time your exercise - Exercising ISOs early in the year gives you the most time to track the stock price and decide to hold or sell before year end
  • Time your sale - ISOs receive favorable tax treatment if held for the right amount of time (see above in taxation) but it’s possible that holding increases your tax bill via AMT or simply isn’t in line with your goals. Selling early (aka a “disqualifying disposition”) will change how your options are taxed but can be a helpful planning strategy in certain situations
  • Take a global view - All strategic planning should be done at the household level with your whole situation in view. That means considering how much risk you’re taking in any one stock, how your plans impact your tax bill both this year and in the future and by considering your personal goals.

Financial Planning for NSOs 

  • Your compensation - NSOs are more common than ISOs and offered to more people including consultants and advisors. It’s important to consider the risk you take by having too much of your compensation tied directly to the stock of a young company. 
  • Time your exercise - You will be taxed at the time you exercise your NSOs, carefully review how you’ll handle these taxes and your liquidity (how much cash you have on hand if you exercise and hold the stock)
  • Take a global view - This point merits repeating, all strategic planning should be done at the household level with your whole situation in view. That means considering how much risk you’re taking in any one stock, how your plans impact your tax bill both this year and in the future and by considering your personal goals.
Doing Your Own Planning?
Click Here to Download our Planning Checklist for NSOs
Click Here to Download Our Planning Checklist for ISOs

What Happens to my Stock Options if I leave or get laid off?

Tech employees facing employment changes need to understand the implications for their Stock Options. Unexercised options may be forfeited, while some companies may have provisions for extended exercise periods or accelerated vesting under certain circumstances. It's crucial to be aware of company policies and plan accordingly. It’s important to remember that if your employer does offer accelerated vesting or alternate exercise terms that employees must update their tax plans and consider their income and expenses in light of these changes (especially if a job loss or change is looming).

Good planning around your Stock Options means not only understanding what ISOs and NSOs are, how they work, and how they’re taxed but also how they fit into your personal goals and plans in the event of life changes like moving jobs.

As financial planners who specialize in working with equity compensation, we have seen how important it is to have a professional on your team to coordinate how you build and preserve wealth so you can lower your stress, pay less in taxes, and focus on reaching your goals. Schedule an Intro Call to get a better understanding of how your Stock Options fit into your plan to build wealth.

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