When to Exercise Stock Options
Employee stock options can be lucrative, but knowing when to exercise your options isn't always straightforward.
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It’s always great to have options. But when it comes to your employee stock options, weighing so many variables can make it challenging to pinpoint the most opportune time to exercise and reap your financial reward.
Before considering when to exercise your options, let’s review the basics.
What are stock options?
Employee stock options are a type of equity compensation that gives you the right (but not the obligation) to buy a certain number of company shares at a specified price. Vesting refers to the point in time after which you are allowed to exercise your options (purchase company shares).
Stock options help to align your interests with that of your employer. The higher your company’s share price goes, the more your options may be worth, providing extra incentive to help drive your company’s success.
There are two types of stock options: exchange-traded options and employee stock options. Here, we’re focusing on the latter.
How employee stock options work
It all starts on the grant date, which is the day you receive options from your employer. The grant paperwork will tell you:
How many company shares you’re eligible to purchase.
What price you’ll pay per share (this is the strike price, also known as the exercise price).
How long until the options vest (that is, how long you must wait until you have the right to exercise your options).
When the options expire (how long you have to exercise your options).
Your stock options give you the right to exercise if and when you want to, but you’re never obligated to do so.
If you choose to exercise your stock options, you can hold on to your company shares or sell them.
Types of employee stock options
There are two primary types of employee stock options, which differ in a few ways.
Incentive stock options, or ISOs. Also known as statutory or qualified stock options, incentive stock options can receive preferential tax treatment. Holding the exercised shares for a certain amount of time can tick the “qualifying disposition” box, meaning you are taxed when you sell the shares, and only at capital gains tax rates. Companies only give ISOs to employees.
Nonstatutory options, or NSOs. These are also called nonqualified stock options. You are taxed at ordinary income tax rates when you exercise, and you are taxed again (at capital gains tax rates) if you sell the shares at a profit. Companies can grant NSOs to outside service providers, consultants or advisors.
» Looking to save on taxes? Learn about strategies to reduce capital gains taxes
Knowing which type of options you have and understanding the different tax implications of each is crucial, as this information may help you decide when to exercise your stock options.
When to exercise stock options
Assuming you stay employed at the company, you can usually exercise your options any time between when they vest and when they expire — typically, this spans up to 10 years.
If you’re leaving your employer, check your grant paperwork to see how long you have to exercise; this is usually referred to as the “post-termination exercise period.”
There are four things to consider when determining the ideal time to exercise your stock options, but it's a good idea to consult with a financial advisor who understands equity compensation and can help you evaluate all the factors of your particular situation.
1. Whether your options have value
It only makes sense to exercise your options if they have value. If the strike price (or exercise price) of your stock options is lower than the market price of your company shares trading on the exchange, they have value.
In this case, exercising your options means you can purchase company shares for a below-market price. Then you could turn around and sell those shares on the stock market and pocket the difference — known as the “bargain element.” This could create a tax bill on the profit, however.
Alternatively, if you believe in your company’s future prospects, you may want to hold on to your options. If your company’s share price rises, your options’ worth will continue to grow while putting off any tax consequences. The longer time frame could give your options even more value.
Don’t forget to keep track of the expiration date. Unfortunately, options with value can end up wasted if not exercised in time.
2. Whether your company is public or private
It makes a difference if your company is publicly traded or privately owned. The considerations in a private company can be trickier.
Shares aren’t traded on a stock exchange, so you’ll need to pay out of pocket to exercise and fund the purchase (instead of selling some of the shares to cover your cost).
You’ll take on the risk of holding illiquid shares that could be hard to sell. It could take a long time before an initial public offering (IPO) or other liquidity event occurs for you to cash out.
If your company is private and files for an IPO, it could be a good time to consider exercising your incentive stock options. Here’s why:
ISOs are subject to a holding period of one year post-exercise — and two years post-grant — in order to qualify for favorable tax treatment.
Once a company files for an IPO, it generally takes several months to prepare before the actual listing.
Immediately upon listing, employees of the company going public are typically subject to a lock-up period where they are restricted from selling shares for up to six months after listing.
By exercising options at the time of filing, the holding time from the filing to the post-lock-up period may coincide with the time requirements for preferential tax treatment.
3. Whether it fits with your financial situation
With many financial decisions, the best time to do something is when it works for you and your unique goals.
Your circumstances may allow you to wait to exercise, which could possibly give the market price of your company shares more time to rise. For example:
You may not need or want additional income from exercising your options and selling shares now.
If you have deferred compensation coming in for a few years, you may want to put off exercising your options until later.
However, you may need cash for some other purpose — to start a business, to fund education or to purchase a home, for example. Depending on the other aspects of your financial situation, exercising your options and selling shares may help you fund another more compelling goal or investment opportunity.
Another thing to consider is your overall financial portfolio and its asset allocation. If you are overly exposed to your company shares, you may want to exercise your options and sell your company shares, using those proceeds to diversify your portfolio.
4. Whether it makes sense for your taxes
Depending on the type of employee stock options you own, you may face varied tax treatments such as ordinary income tax, capital gains tax and alternative minimum tax (AMT). Consider the tax implications of exercising your options and holding on to company shares prior to selling.
For ISOs with a qualifying disposition, there’s typically no tax upon exercise — you’re taxed once you sell your company shares.
For NSOs or ISOs without a qualifying disposition, the bargain element is usually taxed at ordinary income tax rates in the year of exercise.
If you're already in a high income tax bracket, or the additional income from exercising your stock options could push you into a higher income tax bracket, you may want to delay exercising your options or spread the exercise of options out over a few — potentially lower tax — years.
If you’re holding shares in order to receive favorable tax treatment, the bargain element could trigger AMT.
Should you exercise early?
Your company may allow you to exercise employee stock options early (before they vest). This is sometimes referred to as an 83(b) election.
It may seem counterintuitive to pay for something before it becomes yours. And, exercising early comes with additional risk: The shares you buy may never reach the value that you want.
So, why would anyone consider exercising early? First, it starts the holding- period clock for ISOs to qualify for favorable tax treatment. Second, early exercise could help reduce taxes.
If you’re able to buy the shares when the strike price is close to the market price, you can file an 83(b) election to request that the IRS recognize your income at this point in time — before the shares appreciate further.
Since you’ll have earned little to no income from the transaction, you may pay less tax than you might otherwise pay after the shares grow in value down the road.
But note, you'll need to file the 83(b) election within 30 days of exercise.
» Still unsure when to exercise? Learn how to choose a financial advisor.
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