Stock Options Basics: What You Need to Know

Long associated with Silicon Valley startups, nowadays stockA financial instrument giving the holder a proportion of the ownership and earnings of a company. options are becoming a common part of many compensation plans as a means of enhancing benefits and retaining important employees. They offer the potential to participate in the growth of your company, but they often come with complications as well.

This week, we’ll clarify some common terminology and answer some financial planning questions you may have if you’ve received options as part of your compensation package or are considering asking for options at your next review or job change.

What are stock options? They are contracts that allow the holder to buy a stock at a pre-determined price, within a certain time frame.

In the case of options granted as part of a compensation package, that time frame is usually tied to the length of an individual’s employment with the company. Often, you must wait several years before being able to use (or “exercise”) any options you have been granted (the “vesting period”). Options also come with an expiration date; usually 10 years from the date they were granted.

What kinds of stock options are there? Broadly, there are two types of stock options: nonqualified stock options (NSOs) and incentive stock options (ISOs). The main difference? Taxes. NSOs are taxed twice—as ordinary income when they are exercised and at a capital-gains rate when they are sold. With ISOs, you’re only subject to the lower capital-gains rate, if certain conditions are met. For each, there are no tax implications when they are issued.

Depending on how and when you exercise your options, you may owe taxes on the transaction right away—even if you plan to hold on to the stock.

What does it mean to exercise stock options? “Exercising the option” simply means purchasing shares of the stock at the price specified in the contract (the “exercise price”). There are several ways to do this. You may choose to pay for the shares in cash, take out a loan to pay the cost, swap existing shares or use some of the exercised stock itself to cover the cost of the purchase (a “cashless” exercise).

Depending on how and when you exercise your options, you may owe taxes on the transaction right away—even if you plan to hold on to the stock. We recommend that you and your wealth manager work with an accountant to understand the implications if you are receiving stock options and plan to exercise them. We’re always happy to help if you need a recommendation of someone to work with. Please contact us at (800) 492-6868 to learn more.