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5 Things to Know Before Your Stock Options Vest

Your employee stock option plan is a crucial piece of your overall benefits package, therefore it is important to understand what it is and how you can use it to your advantage. 

In the last post, we reviewed what employee stock options were and the terms you need to know to understand your plan correctly. Today, I’d like to discuss what to do if you have accepted an offer and before your stock options vest.

The period before your stock options vest is a critical time to evaluate how you want to use the options once they do. Let’s dive in.

1. Get Back To The Basics

When you are preparing for your stock options to go live, it is important that you have a handle on your specific plan. Knowing the exact numbers and figures will be helpful for exercising them properly. Your stock options can be valuable if you have a sound plan to execute them. In order to do that, you need to know the following:

  • The grant price
    • The price the company allows you to purchase the stock at.
  • Fair market value
    • How much the stock is (or would be) worth on the market.
  • The number of shares you have
    • How many shares your company provided in your employment contract.
  • Exercise date
    • This is the date when your stocks vest, and you are able to use them
  • Expiration date
    • This is the amount of time you have to use your stock options before they expire. 

Each of these components plays a role in your stock option and they are different for each person. Be sure you know the specifics of your plan so you are prepared for your exercise date. 

2. Know The Type Of Stock You Have

Not all stock options are created equal. Many companies will either offer their employee’s incentivized stock options (ISO) or non-qualified stock options (NQSO or NSO). We touched on this difference briefly before, but I want to dive into these two options and what you need to know about them, mainly your tax responsibilities with each. 

ISOs often have nuanced tax obligations. Under most plans, you will not have to withhold taxes at the point of exercising the option. Even though ISOs aren’t obligated for payroll taxes, they are still taxed. Below are the three most common ways ISOs are taxed. 

If you exercise your ISO option and sell the stock within the same calendar year, you will be responsible for paying tax on the difference between the market price at the sale of the stock and the grant price at your ordinary income tax rate. 

To get favorable long-term capital gain treatment, you must sell the shares more than two years after the option grant date and have owned them for over a year (starting with the day after the exercise date). If you exercise your ISO but hold onto the stock, you will be required to pay alternative minimum tax (AMT).

By holding your shares for one year after the exercise date, you could be eligible to pay long-term capital gains tax as opposed to ordinary income, which for a high earner could mean the difference between 18.8% and 35% marginal federal tax rate. 

Non-qualified stock options are a little different. When you exercise an NSO, the difference between the market price and the grant price is considered earned income, and all earned income is subject to payroll taxes. This same principle applies even if you hang onto the stock after you exercise it. Social Security and Medicare are the two places your payroll taxes will go.

After paying your payroll taxes, your earned income is also subject to income tax. If you hold onto the stock for at least a year, you will be eligible for long-term capital gains but that comes with its own set of risks. 

Before making any decisions about when and how to exercise your stock options, it is a great idea to get a professional involved so that they can help you make the best decision for you. Just know that every person is different and what is right for your co-worker, may not be right for you.

3. Create a Payment Plan

When your exercise date comes around and your stock options vest, you will need to have a strategy for how you want to purchase them. Generally speaking, you have three options:

  • Paying in cash
    • Simply send the amount you owe to purchase the stocks (your grant price times the number of stocks you have) to the company who is handling the transactions and then either sell or keep the shares. 
  • Cashless
    • A cashless exercise is interesting because it allows you to sell the number of shares it would take to cover the purchase price and the remaining shares would be given to you.
  • Stock swap
    • This is an exchange of one asset for another. Essentially, you are able to pay with your stock options rather than with cash. 

4. Establish The Stock You Want To Keep

When your stock options reach their exercise date, it is important to think about how much you want to sell and how much you want to keep. This is entirely up to you, but many experts advise not keeping more than 10% and 30% invested in the company. While you may be invested personally and professionally, it is important not to have too much of your finances on the line. 

5. Consult A Professional

Stock options plans can be confusing. With all of the moving pieces, risk levels, tax responsibility, and market volatility having someone in your corner can offer the stability you need to make the most well-informed decision. 

Here at Wealth Habits, we are passionate about helping professionals manage their money and build their wealth in an organic and fulfilling way. Schedule a call with us today and see how we can help you feel more confident and secure with your stock options.