When should you exercise those company stock options? Learn tips for developing a timing strategy to make the most of your equity compensation.
Stock options offer special potential benefits as compensation. Unlike salary, which is taxed when you receive it, stock options defer taxes until you choose to exercise the options and receive income. In the meantime, their value may increase—perhaps significantly. If not, you don’t have to exercise them at all.
But stock options also raise complicated planning questions and require a solid strategy. Here are some points to consider, whether on your own or with the help of a financial expert.
NQSOs are “nonqualified” because they do not qualify for special tax treatment. You pay taxes when you exercise NQSOs.
Example: Suppose your NQSOs have an exercise price of $10 per share. You exercise when the stock price is $12. The difference—a $2 “spread”—gives you $2 per share in ordinary income.
When you exercise NQSOs, your company withholds taxes—income tax, Social Security, and Medicare. When you sell the shares, your proceeds are taxed under the rules for capital gains and losses.
You may feel tempted to exercise NQSOs as soon as they vest and immediately sell the shares. However, you should at least weigh the benefits of waiting to exercise.
Example: Suppose your NQSOs have an exercise price of $15 with a 10-year term. After one year, when the options vest, the stock price has risen to $20. Not bad. However, three years later, the stock price is $35. By the end of the 10-year term, the stock price has risen to $53.
The difference between $20 and $35 (or later, $53) is the “opportunity cost” of exercising the options early in their term. As long as the stock price keeps rising, you can realize bigger gains by waiting than you would by exercising right after vesting.
However, no one can predict the future of a stock price. That’s why it can be helpful to set price and time targets for option exercises and stock sales. By setting automatic actions based on prices and time frames, not a crystal ball, you’re able to leverage the most from your stock options without trying to guess the future of your company’s stock price.
Example: Suppose you have 3,000 NQSOs that expire in three years. You may want to exercise:
When making exercise decisions, balance your timing strategy with your personal circumstances. You may need extra cash now for an important financial goal, such as college tuition. You may want to diversify some holdings out of your company’s stock so you aren’t relying so heavily on that single stock price. Be sure to factor in your tax situation, the likelihood of future grants, and any company stock-ownership requirements.
ISOs offer more favorable taxation than NQSOs. First, they are not subject to Social Security, Medicare, or withholding taxes. Second, if you exercise ISOs and hold the stock for at least two years from grant and one year from exercise, all appreciation over the exercise price is taxed as long-term capital gain, not ordinary income. That usually means a lower tax rate.
However, ISOs present risks. You could be subject to the alternative minimum tax (AMT) when you hold the ISO shares beyond the calendar year of exercise. This becomes even more problematic if you trigger AMT from these unrealized gains on the exercise spread but the company’s stock price then falls. For that reason, one approach to ISOs is to exercise them early in the calendar year, giving you almost 12 months to make a sale decision before the year’s end. If the stock price drops, you can sell before December 31, triggering a short-term capital gain or loss but no AMT liability. Alternatively, with the help of a financial expert, at year-end you can calculate how many ISOs you can exercise without triggering the AMT.
Talk to your TD Ameritrade Financial Consultant about the role equity compensation plays in your overall financial picture.
This article was developed with input from myStockOptions.com.