Dear Carrie: I recently accepted a position at a small startup, where my salary is about the same but I will also get stock options. Can you please tell me what I need to know about company stock options?—A Reader
Dear Reader: First, let me say congratulations! Starting a new job can come with big changes in your life, impacting everything from your role and responsibilities and the people you work with to how much—and how—you’re compensated. I’m glad you’re asking about stock options, not only because they can represent a significant part of your compensation but also because they’re often misunderstood.
In fact, according to a recent Schwab survey, the average vested value of U.S. workers’ equity compensation is about $75,000. At the same time, 85 percent of employees would like their employer to do a better job explaining how equity compensation works. Nearly 2 in 5 employees say they are more likely to need financial advice due to the pandemic.
Stock options are just one of many different kinds of equity compensation. Rather than directly giving you stock as in the case of, say, an employee stock ownership plan (ESOP), with stock options, your employer gives you the right (or the option) to buy company stock at a favorable fixed price for a specific period of time.
In this way, stock options—and any other form of equity compensation—are simply another way for your employer to recruit, retain, and reward valued employees. Unlike a salary, however, they allow you to become part owner of your company. Your employer is encouraging you to think and act like an owner, working harder and smarter. As an owner, you benefit when the share price increases and when the company distributes profits in the form of dividends.
Let’s first take a look at how the two main types of stock options are valued and then review some larger financial planning considerations. In order to maximize this potentially valuable asset, it’s important for you to understand exactly what you own and to keep in mind key dates and milestones.
A Few Basics on Stock Options
When you receive stock options, you’ll also get a written award agreement. This is an important document that contains details you’ll want to keep and refer to before taking any action, including “exercising” your stock options.
Exercising a stock option means purchasing the stock at the fixed price set by the option (the exercise price or strike price). The greater the difference between the stock price and this exercise price, called the spread, the greater the value of the option. Underwater stock options, however, have an exercise price higher than the market price of the underlying stock and thus have no current value.
You can sell your exercised shares (subject to any company-imposed trading restrictions or blackout periods) immediately after purchasing them, or hold and sell them at a later date. Tax consequences chiefly depend on what kind of option you own, when you exercise, and when you sell. There are two main types of stock options:
• Non-qualified stock options (NQSOs) are the most common. Exercising NQSOs triggers ordinary income tax on the difference between your exercise price and the stock’s market value. Your employer will usually withhold income tax, Social Security, and Medicare upon exercise. Later, when you decide to sell the shares, either immediately or after a holding period, any gains or losses will be subject to long- or short-term capital gains tax rules.
• Incentive stock options (ISOs) are less common but popular in the tech sector, both for startups and mature firms. Usually, there are no taxes upon exercise, but exercising can trigger AMT taxes. If you then hold the shares for more than two years from the date of grant and more than 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.
Financial Planning Is Key
As you can see, knowing what type of stock options you own and the company and IRS rules that govern them is critically important. Not knowing can expose you to greater risks, higher taxes, and missed opportunities to build wealth. Here are a few more planning considerations with stock options:
• Vesting: Typically, you must continue to work for a company for a specified length of time before you’re allowed to exercise stock options. This length of time is called the vesting period, which can be all at once or gradually over time. Once you’re vested, you have the right to exercise the shares. On the other hand, you have no control over unvested shares; you can’t exercise or benefit from them until you vest.
• Timing: Because stock options have an expiration date (typically 7 or 10 years), it’s important to think ahead. Waiting until options approach expiration can limit your flexibility in making a more strategic decision and lead to higher taxes. Even worse, your options may expire unused.
• Taxes: Taxation issues related to exercising and selling NQSOs and ISOs can be complex. For example, even if your employer will withhold income taxes when exercising NQSOs, this amount may be inadequate and leave you with a big tax bill. With AMT considerations at exercise and special tax rules around selling, ISOs are even more complicated and require more tax planning.
• Concentration: While it’s great to show your allegiance to your company, taking concentrated bets in any stock—particularly your own company stock—can lead to financial ruin. Stay diversified and use caution when holding more than 20 percent of your portfolio in any one position. Remember, you already have considerable exposure to the financial success of the company as an employee!
Talk to an Adviser and Your HR Department
Sound a bit confusing? It is. And all the more reason to work closely with a financial adviser and tax professional before you make any moves.
Prior to taking action on buying, exercising, or selling, you’ll want to plan ahead and carefully consider the tax consequences, risks, and timing of any options you receive. For advice on your personal financial situation, be sure to consult a tax adviser.
Carrie Schwab-Pomerantz, a certified financial planner, is president of the Charles Schwab Foundation and author of “The Charles Schwab Guide to Finances After Fifty.”