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Understanding Incentive and Non-Qualified Stock Options

26 Apr
Understanding Incentive And Non Qualified Stock Options copy

By: Colleen Weber

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By Colleen Weber, CFP®, CPA

Have you ever wanted to own your own company—but without the hassle of starting, building up, and managing that company? Well, if your employer offers stock options as part of their benefits package, this dream could become a reality. Many employers offer stock options to their employees as a way of fostering a greater sense of ownership and encouraging long-term commitment. But knowing what types of stock options are available and what to invest in can be a little overwhelming. In this article, I will outline the two common types of stock options offered to employees: incentive stock options (ISOs) and non-qualified stock options (NSOs).

Basics of Stock Options

A stock option is a contract that gives its holder the right to purchase stock at a given price (the “strike price” or the “exercise price”) within a set time, but there is no obligation to do so. The holder of an option is said to “exercise” the option by purchasing stock within the time frame allowed, regardless of the market value at that time. So, for example, if the market price rises and you hold a stock option, you can purchase stock at the predetermined exercise price and then turn right around and sell the stock for an immediate profit. It’s important to note that all options come with an expiration date.

Vesting

An employee usually cannot exercise an option until it “vests,” which means that you fully own the option. Vesting occurs on a predetermined schedule, usually after a fixed amount of time, but vesting can also be based on performance milestones. Some employers may offer gradual vesting schedules, and other options vest on “cliff” schedules (where most or all of the options vest at one time). An employer may offer an early exercise provision, allowing options to be exercised before they vest. In the event of early vesting, shares of stock will typically follow the same vesting schedule as the original option contract; if the employee leaves the company before the shares vest, the contract may give the company the right to buy back the shares. The particulars all depend on the terms of the option contract.

Bargain Element

The “bargain element” is the difference between the market price at the time you exercise your option and the grant price of the option. For instance, let’s say you’re granted the option to purchase up to 1,000 shares of stock at $20 per share. The market price increases to $50 per share, and you exercise the full option. You would then pay $20,000 cash and receive shares of stock valued at $50,000. The bargain element is the $30,000 profit that you will have gained on the transaction. That’s a great benefit! It’s important to note that a stock can be sold at any time, even immediately upon exercise of the option. However, in order for the sale profits to qualify as capital gains rather than ordinary income, the shareholder must hold the shares for at least one year. (1)

Clawbacks

One risk associated with taking advantage of employee stock options is something called a “clawback” provision, which gives a company the right to reclaim an option or to buy back shares of stock if certain triggering events occur. Common reasons for clawbacks include financial insolvency of the company or termination of employment. An employment contract can potentially allow for clawbacks even after an option is vested. (2)

Non-Qualified Stock Options (NSOs)

One type of stock option is NSOs. These provide a simple way for employers to incentivize loyalty, but they do not offer the same tax advantages of an Incentive Stock Option (ISO). When you exercise your NSO, you would pay ordinary income tax on the difference between the exercise price and the market price (the bargain element). Since ordinary income is taxed at a higher rate than long-term capital gains, this can make NSOs less attractive for individuals with higher income levels. But the simplicity of NSOs allows employers to offer this type of option more broadly, so it may be the only type of stock option available to you as the employee.  

Incentive Stock Options (ISOs)

ISOs are the more complicated type of option, more commonly offered to senior management. ISOs can sometimes offer tax advantages over other types of stock options, but with some restrictions. When you exercise an ISO, the profits can qualify as capital gains under two conditions: you cannot sell the stock until one year after exercising the option and two years after the grant date. (3) Additionally, the sale of stock purchased from an ISO exercise can potentially incur liability for alternative minimum tax for employees with higher compensation levels. I would advise you to consult your tax professional to determine if this applies in your case.

Your Next Step

Stock options, like employee stock purchase plans, can be another tool in your financial toolbox. While stocks do carry some risk, they can still be a valuable option to diversify your retirement portfolio. There is no one-size-fits-all answer to the question of whether company stock is the best place to invest for your retirement, but that’s where I come in. I’m here to help educate and guide you toward the best plan for your unique situation. So, if your employer offers stock options, or if you would like an overall evaluation of your retirement strategy, call me today at (952) 470-0750 or book a free introductory meeting online! I look forward to hearing from you!

About Colleen

Colleen Weber is a fee-only financial advisor, CERTIFIED FINANCIAL PLANNER™ professional, and CPA with more than 15 years of financial planning experience. Providing comprehensive financial planning and wealth management, she specializes in serving clients nearing retirement, retirees, busy professionals, and women. She is passionate about developing financial plans that save clients on taxes and investment strategies that help them pursue their goals. Learn more about Colleen by connecting with her on LinkedIn or booking a complimentary phone call meeting.

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(1) https://www.irs.gov/taxtopics/tc409

(2) https://www.paycor.com/resource-center/articles/clawback-clauses/#:~:text=What%20is%20a%20Clawback%20Clause,previously%20paid%20to%20an%20employee.

(3) https://www.investopedia.com/terms/i/iso.asp