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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.
What are stock options?
There are two types of stock options: exchange-traded options and employee stock options. Here, we’re focusing on the latter.
Employee stock options are a type of equity compensation that gives you the right to buy a certain number of company shares at a specified price upon vesting. Vesting refers to the point in time in which you receive actual ownership of your options and are able to exercise them (purchase company shares).
Stock options help to align your interests with that of your employer. The higher your company’s share price grows, the more your options will be worth, providing extra incentive to help drive your company’s success.
How employee stock options work
It all starts on the grant date, which is the day you receive a stock option contract from your employer. The contract designates how many company shares you’re eligible to purchase at a certain price (the strike price, also known as the exercise price) after waiting until a particular time (the vesting date). It will also set the expiration date, so you’ll know the time period 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. When exercised shares are held for a certain amount of time, they tick the “qualifying disposition” box and are taxed when company shares are sold, and only at capital gains tax rates. ISOs are exclusively doled out to employees.
Nonstatutory options, or NSOs. Also called nonqualified stock options, nonstatutory options are taxed upon exercise at income tax rates and again when shares are sold — any gains accrued will be taxed at capital gains tax rates. NSOs can be granted 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 exercise your options at any point in time upon vesting until the expiry date — typically, this will span up to 10 years. If you’re leaving your employer, check the fine print in your options contract to see what time frame you have to exercise; this is usually referred to as the “post-termination exercise period.”
Within this 10-year window, there are many considerations when determining the ideal time to exercise your stock options. Here are four to get you started.
Whether your options have value
It only makes sense to exercise your options if they have value. If they do, they’re known as “in-the-money.” This happens when the strike price (or exercise price) of your stock options is lower than the market price of your company shares trading on the exchange. In this case, you could exercise your options, purchasing company shares at the lower strike price. Then, you could turn around and sell those shares on the stock market and pocket the difference — known as the “bargain element.”
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. This optionality or flexibility for a longer time frame gives your options even more value. Of course, there is also the chance that the market price never surpasses the strike price of your options. In this case, your options could expire worthless.
While you wait, don’t forget to keep track of the expiration date. Unfortunately, options with value can end up wasted if not exercised in time.
Whether your company is public or private
It also makes a difference if your company is publicly traded or privately owned. Shares of private companies aren’t traded on the stock exchange so you’ll need to pay out of pocket to exercise and fund the purchase (instead of being able to sell shares and cover your cost). And you’ll also take on the risk of holding on to illiquid shares that could take a long time before undergoing an initial public offering or other liquidity event for you to cash out.
If your company is private and files for an IPO, it could be good timing to consider exercising your incentive stock options. 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 your options at the time of filing, the combined time period from filing until post-lock-up period will hopefully coincide with when you can also satisfy the eligibility requirements to benefit from preferential tax treatment.
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. If your income covers all of your expenses, you may not need any additional income from exercising your options and selling shares. Or, you may have deferred compensation coming in for a few years and can put off exercising your options until later. These scenarios mean you could wait to exercise, which could possibly give the market price of your company shares more time to rise.
However, you may need an infusion of cash for some other purpose — to start a business, to fund education or to purchase a home. 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.
Whether it makes sense for your taxes
Depending on the type of employee stock options you own, you’ll have to consider varied tax treatments such as ordinary income tax, capital gains tax and alternative minimum tax. Besides fitting in with your financial goals and need for income, you’ll want to consider the tax implications of exercising your options and holding on to company shares prior to selling.
For NSOs or ISOs sold without a qualifying disposition, the bargain element of your stock options is usually taxed at income tax rates in the year of exercise. If your income for the year already places you in a high income tax bracket, or additional income from 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.
For ISOs with a qualifying disposition, there’s no tax upon exercise — you’re only taxed once you sell your company shares. If you’re holding company shares in order to receive favorable tax treatment, the bargain element could trigger AMT.
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Should you exercise early?
Your company may allow you to exercise employee stock options early, prior to vesting. This means you would go ahead and pay to purchase company shares, but you’d still be subject to the original vesting schedule before the shares become officially yours and are able to be sold.
It may seem counterintuitive to pay for something before it becomes yours. And, exercising early comes with additional risk: The shares may never reach the value that you want.
So, why would anyone consider exercising early? Because it starts the holding period clock for ISOs to qualify for favorable tax treatment.
Early exercise could help you sidestep taxes. If you’re able to purchase company 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, you’ll pay less tax than if taxes are levied 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? It may be time to talk to a wealth advisor