Non-qualified stock options (NSOs) are a common compensation feature provided to employees as part of a compensation package. If you have access to these perks, they give you the opportunity to potentially profit from the rising value of the company’s stock.
If you find yourself on the receiving end of NSOs, you need to understand what non-qualified stock options are and how they work, including how they could impact your income taxes, investment risk, and financial planning goals.
Here are ten key items you need to know about non-qualified stock options
1 – Non-Qualified Stock Options Are Not Taxed at Grant
When you have non-qualified stock options, you need to know the grant date. That’s the date when you get your company stock options.
Receiving non-qualified stock options is a non-taxable event. You do not owe anything in tax when you receive them, nor are you required to report anything.
Being granted these options simply means your company gives you the right (via the option) to buy a set number of shares at a set price at a future date in time.
2 – Non-Qualified Stock Options Aren’t Taxed When They Vest
The vesting date of NSOs is another important piece of information you need to know about your options. Typically set in the future, the vesting date of non-qualified stock options is the first date you can exercise them.
The exercise of your stock option is akin to buying shares of stock, albeit at the lower price offer via your NSO. Upon exercise, you become an actual shareholder of the company.
You are not required to exercise on the vesting date. But you can if you so choose, and you can exercise on any date after your NSOs vest.
You can’t exercise the right to buy the shares before they vest, even if it would mean you made money. But either way, you won’t owe taxes when your shares vest, nor do you need to report anything for tax purposes just yet.
3 – You Will Owe Taxes When You Exercise Your NSOs
Neither the grant of non-qualified stock options nor the vesting of those options will trigger a taxable event. But when you actually exercise your non-qualified stock options, you will owe taxes. Exercise creates a reportable event for income tax purposes.
Specifically, the amount that will be taxed (commonly known as the bargain element) is equal to the following formula:
Number of Shares Exercised * (Fair Market Value at Exercise – Exercise Price)
This bargain element is taxed as ordinary income to the shareholder, subject to Social Security and Medicare taxes. This means the taxable element shows up in boxes 1, 3, and 5 of a year-end W-2. Ordinary income means the bargain element will be taxed the same as your earned income.
4 – You Might Get a Big Tax Bill When You Exercise
If you exercise your options, you need to be aware that you could end up with a substantial income tax bill. The specific amount of tax you owe will be subject to the number of shares that you exercise and the spread between the exercise price and the grant price.
Using a simple example to illustrate, let’s assume you have 50,000 stock options with a grant price of $1 and an exercise price of $50.
Following our formula above, we can calculate the following:
Taxable Amount: 50,000 * ($50 – $1) = $2,450,000
Assuming a flat tax rate of 35%, your tax bill would be $857,500.
5 – You May Have Several Options to Pay the Tax Bill
Most of us don’t have $857,500 sitting around in our piggy bank that we can use to pay that tax bill. Thankfully, there are several options that can help alleviate the tax pain.
One of the most common methods is known as a cashless exercise (or a sell to cover). A sell to cover exercise is a strategy that allows you to simultaneously exercise and sell some of your shares to cover the cost of your tax bill.
The cash generated via the exercise and sale of some of the shares can then be used to pay the tax due (from a practical standpoint, the tax due is often withheld, similar to your typical W2) as part of the transaction.
It’s important to note that the cash generated from a sell to cover and the actual employer withholding may or may not be enough to cover the actual tax bill. You’ll determine if you underpaid, and owe, or overpaid, and a get a refund when you file. A detailed analysis of your tax return can help with planning around this need.
Continuing our example from above, we can calculate the number of shares necessary to sell to cover the tax bill using the following formula:
Number of Shares to Sell = Tax Liability / Fair Market Value at Exercise
Using our numbers, we know that $857,500 / $50 = 17,150 shares.
In this scenario, an immediate exercise and sell of 17,150 shares would generate the cash required to cover the tax liability. It would also leave you with 32,850 shares, valued at $1,642,500.
6 – You May Owe Additional Tax Later
If we kept using our example above, you’d retain 32,850 shares with a value of $1,642,500 after doing your cashless exercise to cover your tax bill. The amount claimed on your W2 determines their cost basis, which is important because it will determine any future gains or losses.
Over time, the value of the shares you keep will likely fluctuate with the markets. Any future gain or loss (over or under the cost basis) will be taxed as a capital asset subject to short and long-term capital gains rates.
Should you hold the shares for longer than one year from the date of exercise, any gains will be taxed as preferential long-term capital gain treatment. If you sell in less than one year, ordinary income tax rates apply.
All else being equal, it would make sense to seek long term capital gains. However, holding shares for an extra year means retaining investment risk, and you don’t want to make a bad investment decision in an attempt to avoid paying tax.
The best answer to what to do here is one that is customized to you and your needs. A detailed financial plan and detailed liquidation strategy can help determine which strategy is best for you.
7 – Your Shares Will Expire If Unexercised
Non-qualified stock options are not a right into perpetuity. They come with an expiration date, which is often ten years from the grant date. If you don’t exercise your options before the expiration date, your shares simply go away — as will any value have associated with them.
Many recipients of non-qualified stock options wait to exercise their stock options in an attempt to delay or defer taxes. But as you approach the expiration date, the risk of losing all value takes a back seat to the pending tax impact of an exercise.
8 – There Are Many Strategies for Exercising NSOs
When it comes to exercising your options, you may have a lot of options to choose from. The right strategy for you is whichever allows you to meet your goals and objectives with the highest likelihood of success.
One option to exercise your non-qualified stock options is to simply wait until they’re about to expire.
You can clearly identify this is how much you’ll get today, you’ll know how much tax you owe — and you also know if you keep waiting past the expiration date, you’ll get nothing. The clarity in terms of certainty is, for many, a clear solution.
Another strategy may be to exercise your options when the stock price is at its high. But unfortunately, even professional investors find it difficult (dare I say impossible) to easily identify when the stock price is at its high.
A more realistic strategy may be exercising your shares when you have “enough.” Enough maybe the amount required to lead the retirement you want to. Or enough may be the amount required to buy the beach home you’ve always wanted.
Finding the amount that is enough for you is all about determining what is important to you through goal setting and accountability.
For those looking to automate the process, a rolling exercise, a strategy that means exercising a set number of shares each year or a set value each year, can be a great option.
Using our example of 50,000 shares from above, a rolling exercise may suggest exercising 10,000 shares per year, for five years, on July 1st of each year. This strategy removes emotion from the process, manages the tax hit over several years, and averages the price at which you exercise your shares.
Finally, you can have a tax strategy. This strategy may consider the early exercise of stock options to transition the future growth (if any) of the stock from ordinary income to capital gains.
Ultimately, a suitable strategy may be one that is a combination of the concepts above.
9 – Non-Qualified Stock Options Might Leave You Vulnerable to Concentration Risk
As your stock options increase in value, it’s possible that they become an increasingly large portion of your net worth. This risk is commonly known as concentration risk or the risk of having too many eggs in one basket.
If a position in your portfolio equals 10 to 15 percent of your total wealth, you may need to adjust to mitigate that risk.
Concentration risk may be especially concerning for someone with a highly volatile stock and/or someone approaching or nearing retirement. Imagine if you plan on retiring, and the value of your investments drops 20% overnight. A 20% drop in the value of your retirement may mean going from $2,000,000 to $1,600,000 overnight. The impact could be losing an extra $1,000 per month of retirement income.
On the other hand, concentration risk may be one strategy that an informed and willing investor may take in an attempt to generate wealth. In simple terms, bet big to win big.
But this may not make sense for most investors, as the risk of too many eggs in one basket can lead to wild swings in value that most investors can’t stomach. If you’re considering this strategy as part of your plan, I strongly encourage you to seek a professional opinion and to evaluate what might happen if things go bad.
10- Your Stock Options Could Be Worth Less Than You Hoped
For stock options to have value, the stock price needs to appreciate above the grant price at which you can buy the shares. While this is what anyone with stock options hopes for, it doesn’t always happen.
In fact, it’s not uncommon for the share price to go below the price at which you can exercise your option. If this occurs, your options won’t be worth anything.
This can change over time. The share price might rise above the grant price in the short term, creating value for the stock option. But bad news around current events, a poor economy, poor earnings, or any number of factors can drive the price below the grant price.
This volatility is something that is inherent in owning a stock position (or stock option). So what can you do about volatility and risk? You can remove it by selling the stock and eliminating the risk. Or, you can accept the risk and manage it through sound investing and financial planning.
Summing It All Up
The 10 points above address the key “need to know” things about your non-qualified stock options. It’s a nice template to get you thinking about what they could mean to you if your employer offers them.
The key with non-qualified stock options is to evaluate how the key points above (taxation, vesting, financial planning, and investment management) fit into your personal financial plan.
One way to evaluate the “how” is to take a proactive approach to learn as much as you can about taxes, investment management, and financial planning. This website and my newsletters are good resources and starting points if you want to educate yourself. Other books you can read include Stock Options for Dummies and Know Your Options.
A second option is to get a support team at your side, so you don’t have to figure all this out on your own.
Look for a professional or a team you can work with, who has experience blending the multitude of issues that may arise when addressing non-qualified stock options—hiring the right “who” may be the difference in developing a plan and a strategy that allows you to meet your goals and objectives in the most desirable way possible.
This material is intended for informational/educational purposes only and should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product. Hypothetical examples contained herein are for illustrative purposes only and do not reflect, nor attempt to predict, actual results of any investment. The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation. Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.