Let’s face it, trying to understand employee stock options can be a challenge. They are complicated! Trying to understand not only how they work, but more importantly, how they fit into your specific financial plan can be even more difficult to figure out.

And depending on the type of stock options you have, how many you have, other types of employee stock options you own — along with all your other specific financial planning needs — understanding what to do with your employee stock options can become even more difficult to figure out.

Before we get into complexities of how employee stock options fit into a financial plan, it is important to understand the basics of how employee stock options work as they are often confused with other forms of compensation, such as restricted stock.

An employee stock option is the right given to you by your employer to buy (“exercise”) a certain number of shares of company stock at a pre-set price (the “grant,” “strike” or “exercise” price) over a certain period of time (the “exercise period”). Keep in mind, this is a “right” and not an obligation.

Here’s a summary of the terminology you might see in your employee stock option plan:

Grant price/strike price/exercise price – the specified price at which your employee stock option plan says you can purchase the stock

Issue date – the date the option is given to you

Number of shares – which represents the maximum number of shares you have the option to buy. You can opt to buy less than this amount if you’d like, but you cannot buy more.

Market price – the current price of the stock

Vesting date – the date you can exercise your options according to the terms of your employee stock option plan

Exercise date – the date you do exercise your options

Expiration date – the date by which you must exercise your options, or they will expire

When your employer issues your employee stock options, you should receive a document that details the specifics and rules around your options. It is important to have a clear understanding of how they work. Beyond these key points, the documentation around your options should also spell out regarding what happens to your stock option if you leave the company, pass away, become disabled or retire.

HOW MUCH DO I ACTUALLY MAKE?

Your options are considered to be “in the money” when the current market price of the stock is greater than the grant price. If the current market price of a stock is less than the grant price, your options have no value. This would imply that you are buying the stock at a higher price than you could buy on the open market.

Let’s take a look at an example

Let’s assume that as part of your compensation, your company offers you the following stock options):

Employee Stock Option: 1,000 shares

Grant Price: $50

In this example, your company gives you the right to buy up to 1,000 shares at $50 per share, regardless of what happens to the market price of the stock. This right has the potential to be very valuable.

SharesGrant PriceFuture Share PriceValueCurrent Market1,000$50.00$50.00$0.00Good Market1,000$50.00$200.00$150,000Bad Market1,000$50.00Less than $50$0.00

We can illustrate the potential value of these stock options using a simple illustration that looks at employee stock options in both good and bad markets.  For a good market, we will assume a market value is $200 per share and for a bad market value we will assume any price less than $50:

If the future stock price equals the grant price or is lower than the grant price (a bad market), your stock options have no current value. The value in the stock option lies in the opportunity to profit if the stock price goes up in the future. If the stock price is greater than the grant price (a good market), your stock option has a current value.

In our example, you can buy shares of stock for $50 per share via the option. If the stock is currently priced at $100 per share, you can immediately turn around and sell that same exact stock for a $50 profit per share.

If the future market price is below the grant price, you would choose to do nothing. Why buy a stock at $50 per share via your option when you can buy it elsewhere for cheaper?

This short example is a simple version of how employee stock options work and how you have the opportunity to profit from them. But it gets more complicated from here.

The Two Types of Employee Stock Options

Employee stock options are given in two forms:

Incentive stock options (ISOs)

Non-qualified stock options (NSOs)

Both have identical features as discussed above. However, incentive stock options and non-qualified stock options have major differences that are important to understand.

Incentive stock options (ISOs) are employee stock options are given preferential tax treatment by the Internal Revenue Service (IRS) and are not subject to Social Security, Medicare, or withholding taxes. This tax treatment makes ISOs more favorable than NSOs

After you exercise ISOs, if you hold the acquired shares for at least two years from the date of grant and one year from the date of exercise, you incur favorable long-term capital gains tax (rather than ordinary income tax) on all appreciation over the exercise price. Meeting the holding-period requirements of an ISO can result in substantially lower taxes.

If the holding periods are not met, if there was spread on exercise, you will have ordinary income equal to that amount on sale of the stock, and if there is gain beyond that, short term capital gain on that portion, but still no employment tax withholding.

Nonqualified stock options (NSOs) trigger income and employment tax withholding on exercise, if there is a spread on exercise. This is arguably a benefit of an NSO over an ISO because it is easier to calculate the income and employment taxes on an NSO exercise than the Alternative Minimum Tax (“AMT”) consequences of an ISO exercise.

NSOs are much simpler. There is no alternative minimum tax, and no holding period requirements. The gain from the strike price to the exercise price is taxed as ordinary income and flows directly through to your W2.

What Happens When You Exercise Options?

If you have stock options that have value, that means the market price is above the strike price of the option. In this case, you’d likely exercise.

When you exercise your employee stock options, you will be subject to income tax. The amount of tax you pay, and the type of tax depends on the type of options you own. The calculation is also known as the bargain element.

To actually exercise the stock options, there will likely be a formal process by which you notify your employer of your intention to exercise the shares, and they help you facilitate the process through a broker of the stock. Due to the complexity and potential impact on your taxes and long-term financial plan, it is recommended to consult with a financial advisor and CPA for tax advice.

Taxes are important because you may need to come up with cash to pay the pending tax bill or strategize how to execute a cashless exercise. You may also want to strategize how to best minimize, defer, and/or delay the potential tax impact.

It is important to factor your exercised stock options into your financial plan. Analyzing your investment risk tolerance, the overall concentration of company stock on your investment portfolio and your long-term financial goals will help determine the best outcome to achieve the objectives of your financial plan. The risk associated with owning too much company stock could create an imbalance in your asset allocation that exposes you to a higher amount of risk than anticipated.

You Could Make a Lot of Money with Stock Options (But There’s No Guarantee)

One of the best examples of how great stock options could be is the recent payday for Tesla’s Elon Musk. Instead of a salary, Musk opted for all of his compensation to be in the form of incentives and his recent payday could net him over $700 million. Now that is a rare example of how great stock options could be. For a more realistic example, imagine a start-up company that gives you 50,000 company stock options with a strike price of $1 per share. At issue, they probably won’t be worth much. Imagine though, that the price of the stock goes from $1 per share to $100 per share. If that happened, the value would go from nothing to $4,950,000.

Just as with all investments, hearing about the upside is great, but it is important to remember that investments go down as well. Stock options can create a false sense of wealth prior to being exercised. Imagine you had stock options worth a few million dollars that was the foundation of your retirement plan and right before you retire, your company reports bad earnings, or we go through a normal bear market. These possibilities could push your stock price down to the point it wipes out some, if not all of your value.

It is scenarios like this that make comprehensive financial planning important. That is why right now we are providing comprehensive planning at no cost. We will run through a detailed analysis of your complete financial picture while running your portfolio through a number of stress tests to make sure that you are positioned properly. Please use the link below to get started on your analysis today.

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