Non-qualified stock options are a great way to incentivize and reward employees and the management of publicly traded companies. We dedicated today’s episode to exploring the basics of non-qualified stock options. Throughout the episode, Grant reviews how non-qualified stock options work, tax implications, and a few things to keep in mind if you have been granted some non-qualified stock options. Stay tuned until the end of the episode, where Grant talks about some tax planning opportunities that could help you minimize the amount of tax you have to pay in the long run.
Non-qualified stock options (NSOs) are a very popular way to compensate employees at publicly traded companies, and a wonderful benefit to receive. But the tax consequences, and how to handle them, can be confusing.
How you handle an NSO grant should depend on your personal financial situation: your objectives, your tax situation, your cash needs, the rest of your portfolio, etc. Managing your NSOs thoughtfully can lead to a huge tax savings over time. Managing them haphazardly can lead to an unwanted (and unneeded) bill to the IRS.
This post will cover how NSOs are taxed, and a few questions you should ask yourself before deciding how to handle them.
Employee stock options can be a wonderful form of compensation. Unfortunately, far too many employees leave money on the table when managing them. Here are the top five mistakes you should strive to avoid:
1) Underappreciating Tax Liabilities
There are two types of company stock options: incentive stock options (ISOs) and non-qualified stock options (NQSOs). They differ in structure, who they’re offered to, and how they’re taxed. Here’s a good review of both.
In order to maximize the value of a stock option grant, employees should always try to minimize the resulting tax liabilities. Stock options can be tricky creatures from this perspective since the option grant, exercise, and resulting stock sale can all be taxed differently. Exercising ISOs can even subject employees to the alternative minimum tax (cue shudder). Thus, tax minimization should be a focal point of any long term stock option strategy.
2) Exercising Options and Selling Shares Immediately
Rather than exercising and selling immediately for a profit, it’s almost always better to exercise employee stock options and hold the shares for at least a year. By doing so, the difference between the sale price and strike price is taxed as a long term capital gain instead of ordinary income.
Since long term capital gains are taxed at lower rates than ordinary income, this can be a big tax saving technique. Also, keep in mind that incentive stock options must also be held for two years after the grant date to qualify as long term capital gains.
3) Forgetting About Them Until It’s Too Late
The very worst case scenario is when employees forget about stock option grants and allow them to expire unused. While not nearly as costly, another common mistake is neglecting options until they approach expiration. Allowing the exercise window to close limits your options, thwarting the benefits of a thoughtful long term plan.
Employees should start thinking about their stock option strategy immediately after they’re granted. Starting early leaves you the most flexibility, and the best opportunity to minimize taxes and maximize their value.
4) Neglecting Stock Plan Rules Before Resigning
Most companies force employees to exercise stock options upon termination of employment. Normally they have 90 days to take action, but the window varies from place to place.
This window for stock options will also be different than the windows for severance packages and other benefits, making things a bit confusing. Before tendering resignation, be sure to understand your company’s stock plan and set a strategy accordingly.
5) Failing to Account for a Merger or Acquisition
Mergers and acquisitions affect employee stock options in several different ways. Sometimes vesting schedules accelerate, while in others the existing company’s shares will be phased out and replaced with the new company’s.
When going through a merger, employees should keep abreast of how management is handling their stock plan, and adjust accordingly. If necessary, pester HR for up to date information. The only way to maximize stock option value is to concoct a strategy with up to date data.