Know Your (Stock) Options: Understanding ISOs and NSOs

Equity Compensation | Incentive Stock Options | Stock Options | ISO | NSO | Nonqualified Stock Options

 Brian King By: Brian King

Companies use stock options as a form of equity compensation to supplement employees’ salaries — and if you’ve been awarded options, you’re essentially being given a chance to take an ownership stake in the company you work for. Stock options are not only an acknowledgement of the contributions you make to the success of the business (and an incentive to keep you working hard!), but they can also help you build wealth and achieve important financial goals.

Making the most of that opportunity, however, requires understanding how stock options work and what kind you’re being offered, so you can find the best way to use them to achieve your financial goals.

The two most common forms of options are incentive stock options (ISOs) and nonqualified stock options (NSOs) — and they both come with slightly different rules and tax treatments that can affect how you might use them.

The Basics of Stock Options

Whether you’ve been awarded ISOs or NSOs, both types of stock options give you the right to buy company stock at a future date and for a predetermined price. The financial benefit of stock options comes if the share price rises between the day you receive the award and the day you exercise your options — giving you the chance to buy company stock at a discount to market value.

To help manage your stock options, here are some of the key terms and milestones in the lifecycle of a grant you need to know:

  • Grant date — The day you receive an options award, which establishes how many shares you can purchase, the exercise price (or strike price), and the countdown before you exercise your options.
  • Vesting period — The waiting period before you can exercise your stock options. Options can either vest in stages (such as a percentage of the overall award each year for 5 years) or all at once at the end of the vesting period.
  • Exercise period — The time you have to exercise vested options, which involves purchasing the shares for your strike price.
  • Expiration date — Deadline to exercise optioned shares, which is often 10 years after the grant date. If you don’t use them by the expiration date, you lose them.

Understanding Different Tax Treatments

Stock options don’t impact your finances until you actually exercise them — and the first thing you’ll need to do is manage the taxes associated with your shares. Taxation is where one of the key differences between ISOs and NSOs emerges. In broad strokes, NSOs have less of a tax advantage but are simpler to navigate. ISOs come with a tax benefit but a few more rules and slightly more complicated math. Let’s look at them one at a time:

NSOs

When you exercise NSOs, you owe income tax and payroll taxes on the difference between what you pay for the shares and what they’re worth.

  • Let’s say you exercise 1,000 options at a strike price of $35 per share, and the stock’s current price is $47. You would be taxed on $12,000 of worth income ($47,000 - $35,000).

Your company may automatically withhold the mandatory minimum 22% for federal taxes—as well as any state minimum withholding—but there’s a good chance your actual tax rate is much higher. It’s important to run a tax projection when planning to exercise options so you don’t face a big extra liability when you file for taxes for that year.

Read More: How Tax Projections Help You Make Better Financial Decisions

Once you exercise the options, you can sell or hold those shares. If you hold those shares for at least one year after your exercise date, you’ll qualify for the long-term capital gains rate on any gain or loss you record when you sell them. The capital gain or loss will be calculated based on the shares’ fair market value on the date of exercise.

ISOs

One of the advantages of ISOs is that you don’t own income and payroll taxes when you exercise — as long as you hold those shares for at least one year after the exercise date.

However, ISOs are not exactly tax-free. The difference between what you pay for the shares and the stock’s fair market value counts towards your alternative minimum taxable income (AMTI).

  • Imagine the same example we used above was for an ISO grant: You wouldn’t owe income tax and payroll taxes on the $12,000 difference between your strike price and the stock’s fair market value, but you have to add the $12,000 to your AMTI.

If you end up owing AMT (which has become less likely for all income levels since the Tax Cuts and Jobs Act took effect in 2018), you would be taxed at a rate of 26% or 28% on that $12,000.

Then, as with NSOs, holding on to shares purchased from an ISO grant carries capital gains implications: Any gain or loss will be measured from your exercise cost — even if you’ve already paid AMT on the spread.

How to pay for your options when exercising

Because options represent the right to purchase company stock at a potential discount, you still need funds to cover the transaction. Here are common techniques to cover those costs.

RSOs:

To avoid putting up cash to cover RSO exercise costs, you could:

  1. Sell to cover. You can direct your employer to sell enough of your exercised shares immediately to cover the total exercise value, taxes, and other costs, leaving you with the remaining shares.
  2. Exercise and sell. Alternatively, you can direct your employer to immediately sell all exercised shares and to cover all taxes and costs with the proceeds, leaving you with cash.

ISOs:

Selling shares to cover exercise costs can negate some of the tax benefits of ISOs. Instead, you could use:

1.      A cash exercise. If you have sufficient savings in another account, you can pay upfront to cover the strike price and taxes/fees associated with the exercise, and retain all of your shares.

2.      A stock swap. If you already own company shares—such as those purchased previous options grants—you can swap the number of those shares needed (based on current market value) to cover the exercise costs of you new options. However, you will still need cash to cover taxes and fees.

 

So You’ve Exercised Your Stock Options — Now What?

Deciding what to do with your newly acquired company stock depends on a lot of variables, such as:

  • Taxes
  • Your financial goals
  • The rest of the investments in your portfolio

It helps to talk with a financial advisor to view an options package in the context of your immediate or longer-term needs.

Many professionals think about stock options as similar to a cash bonus. They calculate a potential future value and earmark those assets for a specific purchase, such as buying a new home. If you have similar objectives, then it can make sense to exercise and sell all your options at once (Or, in the case of ISOs, to hold them just long enough to keep the tax advantage).

On the other hand, a lot of professionals think about the growth potential of their company stock and want to hang on to those shares for longer-term goals like boosting retirement savings. Remember, though, that a big options award can lead to a concentrated position in one stock. That’s always risky, but it’s especially dangerous when you also depend on that company for your salary. If something goes wrong, your income—and your long-term savings—can take a big hit.

If you’re enthusiastic about holding shares in your company, that position shouldn’t exceed 10% of your overall portfolio. And if you still want growth potential out of your options award, you can sell your company shares and use the proceeds to buy a diversified mix of other stocks or mutual funds.

This kind of flexibility helps make stock options a powerful tool for meeting current financial needs or building wealth. Even better, they come with a built-in waiting period before you actually take control of those assets. Use that time to think carefully about your financial goals and consider the potential tax implications of exercising your options (asking your advisor to run tax projections can be a big help here). That way, you’ll be in a good position to make the most of the opportunity when your exercise period arrives.

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Disclosure:

This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors.

 

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Brian King joined the Plancorp team from PricewaterhouseCoopers, LLP in 2008. Now our Chief Planning Officer, he brings his advanced income tax and estate planning experience to Plancorp’s family office practice, where he helps families understand, grow and preserve their wealth. More »