O'Connor: The ins and outs of employer-granted stock options
Many companies offer their employees benefit programs that include everything from medical insurance to a 401(k) retirement plan. But, as an employee of a publicly-traded company, you may also have another benefit that could prove to be extremely valuable. For the first time in your career, you could have access to employer-granted stock options.
A stock option is the right to purchase a company's stock in the future at a fixed price. When you exercise an option, you purchase shares of the company's stock directly from the company at the grant price, a price set by the company at the time the stock option grant is made.
The timing and strategy used when exercising stock options is tied to four primary variables: vesting, expiration, taxes and stock price. While you may be able to make big profits on your options if the stock price appreciates substantially beyond the grant price you will pay, there are other things like vesting schedules, expiration dates and the rules guiding the various types of options you may want to consider before taking any leaps.
Below, we will explore the specific rules regarding vesting schedules, expiration dates and the two types being offered.
Vesting Schedules: Most options are granted subject to a vesting schedule, which refers to the dates on which options can be exercised. This schedule may significantly affect the timing of your option exercises so you should be well versed on your company's rules. By instituting a vesting schedule, an employer may require you to complete a period of service after the option has been granted before it can be exercised.
Most often the schedule will either be on a graduated or cliff-vesting format. If it is a graduated vesting schedule, some percentage of the options become exercisable at regular intervals over a certain period. For example, a common graduated vesting schedule requires that employees wait one year from the grant date before any of the options are exercisable. On the first anniversary of the grant date, 20 percent of the options can be exercised. Under this type of schedule, the remaining options will continue to vest at the rate of 20 percent per year for the next four years until all of the options are fully vested.
The cliff vesting schedule stipulates that the options will all become available at some future time. A common cliff-vesting schedule provides that none of the options granted can be exercised within the first three years following the grant date. On the third anniversary of the grant date, all of the options are immediately available for exercise.
Expiration dates: Expiration dates refer to the end of the option's life. Stock options are usually granted for a specific period and must be exercised within that period. A common option term is 10 years, after which, the option expires. You should be aware of the terms of your stock option plan with respect to any changes in these dates. Employer-granted stock options can be a very valuable addition to your compensation package and your portfolio. Just remember to remain well-versed in the rules of your company's plan so you can continue to benefit for many years to come.
If you have access to employer-granted stock options, you may already understand that a stock option is the right to purchase a company's stock in the future at a fixed price. And you also may know that in order to exercise an option, you must purchase shares of the company's stock directly from the company at the grant price – a price set by the company at the time the stock option grant is made. In the best-case scenario, the price of the stock would appreciate beyond the grant price you will pay, which would allow the value of your option to also appreciate.
In order to become well versed in this unique benefit, you should also understand the various types of options. Stock options come in one of two forms: incentive stock options or nonqualified stock options. The primary difference between the two types is how you will be taxed upon exercising the option.
Incentive stock options: ISOs are not taxed at exercise but rather when the shares are sold. When you are granted incentive stock options there are no immediate tax consequences. The notable exception is that the exercise may cause you to be subject to the alternative minimum tax or AMT. When you eventually sell these shares, the difference between the selling price of the stock when sold and the cost basis (grant price) is the income you must consider for tax purposes. As long as you have held the stock for the required holding period, which is at least one year from the date of exercise and two years from the grant date, the entire difference between the selling price for the stock and your cost basis will be taxed as long-term capital gains. It is important to note that the rates for long-term capital gains are very favorable when compared to the tax rates for ordinary income.
Nonqualified stock options: As the most common type of options granted by companies, you will probably become more familiar with NSOs. Like ISOs, there is no taxable event created when NSOs are granted, however, a taxable event does occur when you exercise NSOs. And unlike the ISO, this taxation occurs whether you sell the resulting shares immediately or continue to hold them following exercise. When an NSO is exercised, you must recognize that the taxable spread – which is the stock price on date of exercise minus grant price – will be taxed as ordinary income. So, this income will be considered as part of your total compensation and will be included in your W-2.
Once shares are exercised, your cost basis for the NSO shares will be equal to the stock price on the date of exercise. If you elect to hold the shares following exercise, this cost basis will be critical to computing your future gains or losses when you eventually sell the stock. At the time of a sale, you will recognize a capital gain or loss equal to the difference between your cost basis and the price at which you sell the shares. If you sell within one year of the date of exercise, the capital gain or loss will be considered short-term. But, if you sell the shares more than one year after the exercise date, a long term capital gain or loss will result.
Your employer-granted stock options can be a valuable benefit if you put together a well thought out plan for exercising them. Just remember the ins and outs of your company's plan so you may continue to enhance your portfolio in the future. Wells Fargo Advisors Financial Network is not a tax or legal adviser, however we will be happy to work with your chosen adviser to help you reach your financial goals.
• Patrick S. O’Connor , CRPC is the Managing Principal, Senior Financial Advisor and a Chartered Retirement Planning Counselor CRPC at Wells Fargo Advisors Financial Network off of Randall Road next to the new Hobby Lobby in Algonquin. He can be reached at 847-458-0142, emailed at email@example.com or at www.algonquin.wfadv.com.