What are stock options?

A stock option gives an investor the contractual right (but not the obligation) to buy or sell a stock at an agreed-upon price and within an agreed-upon timeframe. 

An important distinction: an option is not itself a share of stock. An option is a derivative, meaning that its value derives from the value of an underlying security or asset (in this case, the company’s stock). 

When two parties agree that they have the option to sell or buy a stock at a specified price, regardless of that stock’s actual share price, within a set period, they have entered an “option contract.”

How do employee stock options work? 

Let’s use an example. Suppose you start working at a tech startup. In that case, the company may supplement your compensation with an agreement to sell you 2,000 shares of the company’s stock at $10 per share, at any time over the next ten years, with your right to exercise your options beginning after a one year waiting (or “vesting”) period. 

(This is just a hypothetical; actual details may vary depending on the company.)

If the stock’s share price falls below the fixed price agreed upon in your option, you are still bound by that original price if you wish to exercise your options. You are not obligated to do so, but if you took a lower salary because of that stock option’s potential for growth, you could end up losing out.  

Likewise, if you leave the company before you become vested or do not exercise your options within ten years, they reabsorb into the company. This would come at no cost to you, but you wouldn’t get rich, either.  

On the other hand, if it turns out you are working for the next Microsoft or Apple, and the share price of the stock soars, you can exercise your option to purchase at the predetermined lower price and collect your fortune. 

If your option price is fixed at $10 per share, for example, but the market share price is now $100, you can exercise your option, then turn around and sell for shares for a $90 profit. 

There are, however, tax implications. 

How are stock options taxed?

There are two basic categories of employee stock options (ESOs):

  • Statutory (qualified) stock options are granted as part of an employee stock purchase plan or incentive stock option (ISO) plan. 
  • Nonstatutory (nonqualified) stock options are granted without any plan.

The employer determines the type of option offered to an employee, and the main difference between these two categories is the way the IRS treats them for tax purposes. 

The good news is that you are unlikely to incur any taxes when you receive the option in both cases. 

Statutory (qualified) stock options

Qualified stock option plans offer tax advantages and must comply with specific IRS rules. Most statutory stock options do not produce any immediate taxable income until you sell the stock. 

Therefore, most qualified stock option plans require you to purchase shares and hold them for at least one year before selling. After that year, any gain on the sale is subject to favorable capital gain tax rates. 

Nonstatutory (nonqualified) stock options

Nonqualified stock options have fewer restrictions than qualified stock option plans. But they come with different tax consequences.  

If you purchase stock at a discount under a nonqualified plan, the difference between purchase and market prices is taxable as income. So if you buy the stock at $10 and the market price is $100, you will have $90 of taxable income.

The option grant may also be taxable, but only if you can easily assess the fair market value of the option if, for example, it is already trading on an exchange.

Another critical point: the term “nonqualified stock option” is a technical term describing certain types of stock options granted to employees. The term refers to how the IRS taxes the gain, not to the legitimacy of the transaction.

Where do I report my stock options?

Exercising your statutory or qualified stock option is generally not a taxable event in the usual sense. However, it can result in an Alternative Minimum Tax (AMT) adjustment. 

The AMT exists to ensure that filers who earn above a certain income level are still liable for a minimum tax payment regardless of how many deductions or loopholes they may apply. 

The best way to determine whether you owe anything towards the AMT is to fill out Form 6251. If the tax calculated on the form is higher than that on your return, you will need to pay the difference as Alternative Minimum Tax, in addition to your regular income tax. 

On the other hand, Nonstatutory or nonqualified options do generate income tax on the difference between the current fair market value of the stock and the price you paid for it. 

So if your $10 stock is now worth $100, you will pay tax on the $90 you made if your option was nonstatutory. 

In that case, your employer will usually report your profits as income on your W-2, and it will already be part of your taxable wages, with no additional action needed from you. 

How do I get the most out of employee stock options?

Much of getting the most out of your employee stock options comes down to timing. 

Remember, your vesting schedule won’t last forever, so be sure to act before your options expire.   

Before you exercise your options, make sure you fully understand the cost, including how it will impact your tax bill. Small mistakes can lead to much higher taxes, so the time to be proactive about your financial planning is now. 

Another best practice to keep in mind is that more diverse portfolios are generally considered lower risk. General advice is not to concentrate your investments on a narrow portfolio. Many advisors suggest that stock in a single company should not comprise more than 10-15% of your portfolio. 

You can also spread out the sale of your stocks over time to cushion their value against market fluctuations and decrease the percentage of your portfolio. 

Finally, the best advice is to work closely with a tax professional to make sure you understand your financial situation, know your options, and have the support you need to feel confident in your decisions. 

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