If an employer offers stock options, this is a great way to increase someone’s net worth but there are things to consider when exercising stock options.
The Different Types of Stock Optons
Not all stock options are created equally and are typically one of the following:
- Incentive Stock Options (ISO)
- Nonqualified Stock Options (NQSO)
- Restricted Stock Units (RSU)
- Stock Appreciation Rights (SAR)
- Employee Stock Purchase Plan (ESPP)
Each One of these stock options offers its own monetary value and tax concerns, and I plan to write about the different options in a future post.
How Stock Options Work
When an employer awards an employee stock options, this is known as a grant. A grant will determine the guidelines of the award like:
- Type of stock option
- Quantity received
- Grant price
- Date stock option becomes available (aka vested)
For example, XYZ company awards their employee 24 stock options on January 15, 2021, and two units will become available to obtain every month on the 15th until Dec 15th, 2021. The grant price is $50
- Jan 15, 2021 – 2 stock units available to exercise
- Feb 15, 2021 – 2 stock units available to exercise
- Mar 15, 2021 – 2 stock units available to exercise
- Apr 15, 2021 – 2 stock units available to exercise
- May 15, 2021 – 2 stock units available to exercise
- Jun 15, 2021 – 2 stock units available to exercise
- Jul 15, 2021 – 2 stock units available to exercise
- Aug 15, 2021 – 2 stock units available to exercise
- Sep 15, 2021 – 2 stock units available to exercise
- Oct 15, 2021 – 2 stock units available to exercise
- Nov 15, 2021 – 2 stock units available to exercise
- Dec 15, 2021 – 2 stock units available to exercise
This is just an example of what a grant offer can look like and the terms will be different for each grant.
What To Do Once Stock Options Become Vested
A vested stock option means that someone reached the date that a stock option is available to exercise. An unvested stock option means that the person hasn’t reached that date yet. Once the stock option becomes vested, four things typically happen.
- Exercise the option, and keep the stocks to sell later
- Exercise the option, then immediately sell the stock to take the cash
- Exercise the option, and keep some stock and take the rest in cash
- Don’t exercise the option (not a taxable event)
Think of stock options like a coupon to get a stock in the future. Once someone exercises their stock options (or uses their coupon to get their stocks), those stocks are that person’s to keep. They can’t be taken away.
If someone leaves their job before their stock options are available, then those unvested stock options go back to the company. If someone has stock options available to them, then they typically have 30 days after they leave their job to exercise any stock options they have available. The guidelines change from company to company though.
Tax Considerations
Anytime a stock option is exercised, it is a taxable event and someone can pay for the taxes by:
- Having money set aside from every paycheck beforehand
- Selling a portion of the stock options
- Example: If someone is exercising ten stock options, they might have to sell four of them to pay for the taxes owed and they will keep the other six.
- Having the cash available in the brokerage platform that is being used.
If stocks are held to be sold later, they are going to get taxed twice. Once on the value of the stock received and another time when the stock is sold.
Let’s say someone exercises 10 RSUs at $50 each, that means that person will gain $500. This means Federal, State, Social Security, and Medicare tax needs to be paid on this amount. Here is an example of what someone could pay. (These numbers can change on the type of stock option exercised and someone’s individual tax situation).
- Marginal Federal Tax Rate – 24%
- Marginal State Tax Rate – 8%
- Social Security Tax – 6.2%
- Medicare Tax – 1.45%
So this person has to pay 39.65% on the $500, which comes to $198.25. This is what someone’s tax consequence could be on exercising their 10 options.
If someone exercises a lot of stock options in one year, it can bump them into a higher tax bracket and it might make more sense to exercise the options over two or more years.
For the first gain, someone can choose to immediately sell all their stock (or a portion) for cash and they can use the money to pay for the taxes. This means that the person will have $301.75 leftover ($500 minus $195.25). Or the person can choose to pay the taxes from another source and keep the stock.
Normally if using cash from a stock sale is used to pay for the taxes, the broker will hold 20% of the amount sold as a federal tax withholding. For many folks with stock options, the withholding is too little, so it is wise to understand what are the estimated taxes owed so that there are no unpleasant notices from the IRS in the future.
If the decision is to keep the stock, then another tax consequence will happen on the appreciation or depreciation of the stock. If the stock was obtained at $50 and was later sold at $75, this means there was a $25 capital gain. ($75 current stock price minus $50 excise price)
If the capital gain happens within 366 days of obtaining the stock, then the sale will be considered a short-term gain and will face federal and state taxes. If the stock is old after holding it for 366 days, then they will be taxed at long-term capital gain rates, which are:
- 0% if a single filer makes less than $39,375 or a married filing jointly makes less than $78,750 in 2020
- 15% if a single makes between $39,376 and $434,550 or a married filing jointly makes between $78,751 and $488,850
- 20% if a single filer makes over $434,550 and a married filing jointly makes over $488,850
State tax rates will also apply to long-term rates as well depending on the state.
It’s important to keep track of the price that the stock was acquired and the selling price because the custodian doesn’t always give accurate information on forms 1099-DIV and 8949, which are needed to file your taxes. It’s up to the tax filer to keep accurate numbers.
Diversification
As the old saying goes, you don’t want to keep all your eggs in one basket. So it is recommended that someone doesn’t keep more than 5% of their net worth tied up into one stock. This doesn’t apply to everyone and depends on the following questions.
- How close am I to retirement?
- How big are my assets?
- How volatile is the stock?
- How is the company doing financially?
- If the stock goes down in value, can I handle that loss or wait for the stock to recover? (recovery is not guaranteed)
- Do I believe the stock has a big upside for financial gain?
- Am I on track with my other financial goals?
- Can the proceeds from the sale of the stock options be put to better use?
- Do I have the money to pay for the taxes and keep the stock?
There are many factors to consider on how much of the stock options should be kept and how taxes play a part.
The biggest goal from managing stock options is to maximize their value based on someone’s personal factors and goals. This is how I talked to my clients to help them think about their stock options.
Before you make any changes to your financial plan or situation, please do your research or contact a professional like myself.
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