Yes, a consistent paycheck and 401(k) is nice, but these days it seems like all the cool kids are getting a lil’ something extra in their compensation packages. That “something” is called stock options (oooooh!).
The term sounds shiny and sophisticated, like the millennial version of a gold watch — except in this case you can get it before you retire. But stock options aren’t actually limited to the professional elite: they can be a major perk for employees of all levels, at scrappy startups and international titans alike.
What are stock options?
As the name implies, stock options give you the option (but not obligation) to buy shares of stock in a company. An option contract will specify how many of those shares you can buy, and at what price, and within which periods of time. That’s a lot of variables, I know; but this mini-glossary (adapted from Russell Kroeger’s deep dive on the topic) helps keep them straight:
| GRANT DATE | Date at which the options are given to the employee. |
| VEST DATE | Date at which ownership of the options is fully transferred to the employee, making them “exercisable.” |
| EXERCISE | The practical use of the option to purchase company shares |
| GRANT PRICE (a.k.a. STRIKE PRICE, a.k.a. EXERCISE PRICE) | The fixed price at which the employee can exercise the option to buy a share of the company – only available to them until the option expires |
| EXPIRATION DATE | The last day the employee can exercise their options, after which the option becomes worthless. |
How do you use them?
Suppose you’re an Apple employee and, as part of your comp, you receive ten options on shares of AAPL stock. These options are fully vested on the grant date (i.e. today), their expiration date is one year from now, and their exercise price is $100 per share.
In other words, you can buy ten shares of AAPL at a locked-in price of $100, regardless of its share price on the open market, anytime within the next year. Therefore if AAPL’s market price is higher than $100 per share, you can exercise the options and effectively buy the shares at a discount. That, in a nutshell, is the beauty of stock options.
Exercise
You face a choice when you exercise your options. You can immediately turn around and sell the underlying shares for a profit, or you can hold onto them in hopes that they’ll fetch a better price in the future. Correspondingly, there are two disposition methods for exercising options:
- Cashless Transaction – You exercise the option then immediately sell the corresponding shares – or, rather, a brokerage does so on your behalf. This earns you a profit equal to (current market price – exercise price) x (# of shares) without requiring you to pony up the cash to buy the shares yourself.
- Exercise & Hold – You exercise the option and take receipt of the corresponding shares, but hold onto them instead of selling. This method requires that you have enough cash in your account to pay the exercise price. For example, if you want to exercise and hold 10 AAPL options at a strike price of $100 each, you must have at least $1,000 in cash on hand to complete the order yourself.
Vesting
The above example assumes your options are already fully vested, but what if they’re not? Suppose they are subject to a vesting schedule. This means that although the options are visible to you in your account, they are not actually yours until after a specified date.
If you leave the company before the stated vesting date, you lose the options. This is how employers incentivize good employees to stick around.
Vesting schedules typically cover multiple years and allow chunks of the options to vest at the end of each year. For example, if your 100 options have a 4-year vesting schedule, this doesn’t necessarily mean you have to wait four years to exercise any of them. Rather, ¼ of the total grant amount will vest – and therefore be exercisable – at the end of each year.
How are stock options taxed?
There are two types of stock options: NSOs (non-qualified or non-statutory stock options), and ISOs (incentive stock options). The biggest difference between the two lies in their respective tax liabilities.
NSOs — Non-qualified Stock Options
NSOs are taxed first when you (1) exercise your options (more on what that means on the blog) and again when you (2) sell the underlying shares. That is:
- Upon exercise, you’ll pay income tax, Medicare tax, and Social Security tax on the difference between the share’s current market price and the price set in your option contract (i.e. the strike or grant price).
EXAMPLE: Your 10 NSOs have a strike price of $100, and after they vest, you exercise them at the current market price of $150. At the time of your exercise, your employer or broker will withhold applicable taxes on $500.
($150 – $100 x 10 options = $500)
- Upon selling the underlying shares, you’ll pay capital gains tax on the difference between the sale price and your grant price. But in addition, the amount of tax you previously paid on the shares will be added to your grant price, reducing the taxable difference.
EXAMPLE: Having exercised your 10 options, you’re now ready to sell the underlying shares at the current market price of $210 each. Let’s assume you paid $152 in taxes upon exercise, per section (1) above. So you now have $448 of taxable capital gains income.
($210 – $150) x (10 shares) – $152 = $448
ISOs — Incentive Stock Options
Unlike NSOs, ISOs are only taxed when you ultimately sell your shares. If you exercise and sell your shares within one year, you’ll owe short-term capital gains tax on the difference.
EXAMPLE: Your options have a strike price of $100, and when you exercise them the underlying shares are worth $210 each. If you sell them now, your taxable capital gain will be $1,100, taxed at the short-term rate.
($210 – $100) x (10 shares) = $1,100
But if you exercise and then hold your shares for more than a year, you’ll owe Alternative Minimum Tax (AMT) in the year you exercised the options, as well as long-term capital gains tax when you ultimately sell the shares.
AMT and Capital Gains Tax
It’s important to note that the long-term capital gains tax is lower than the short-term one, so holding onto your shares for a year or more after exercise could reduce your tax liability. On the other hand, your AMT may or may not offset that difference.
AMT is a separate tax calculation that your accountant runs alongside your normal income tax. When he or she is done with your taxes, they are left with two numbers: your calculated income tax and your AMT. You, the taxpayer, must pay the higher of the two.
There are many factors that go into calculating one’s AMT, one of which is ISO exercises. If you choose to exercise your ISOs and hold onto the shares for at least one full year, your AMT will increase according to the difference between 1) your exercise price and 2) the market price on the exercise date. This amount is also known as the bargain element.
Although that all may sound complicated, ISOs generally have a big advantage over NSO’s – hence the “incentive” part. In addition to the tax break, they also have a degree of exclusivity: while a firm can offer NSOs to its contractors, vendors and partners, ISOs are reserved for employees only.
On the other hand, ISOs always have a vesting schedule, which means you forfeit them if you leave your employer before they’re fully vested. Often, this works out as a win-win arrangement: employees like the tax break and exclusivity of ISOs, while employers like convincing their people to stick around for the long term.