Understanding Your Employee Stock Options

Employee stock options are a common benefit in the technology industry. Not only do they incentivize employees to stick around, but employees benefit directly from their hard work in the form of ownership in company stock. For some individuals, their stock can become a large portion of their net worth as they can be extremely lucrative. While the benefits are apparent, it's important to understand potential risks, tax consequences and how they fit into your financial plan.

Stock Option Lingo

Below are the key terms often associated with stock options.

Grant Date

Typically, a company offering employee stock options will have grant dates for employees. Ownership isn't given to employees straight out of the gate - they require a certain amount of time at the company before they're granted.

Vesting

The date that the granted options vest is when you gain full control of the options. Once vested, you're able to choose when to "exercise" the right to buy your employer's stock. The vesting schedule differs among employers, with some using a cliff and others using a graded schedule. For example, a cliff schedule would vest all the granted options after three years and a graded schedule would vest the granted options over a period of five years. (For related reading, see: Employee Stock Options: Introduction.)

Exercise Price

This is the price at which you have the right to buy the stock once it's vested. What makes stock options valuable, aside from the fact you're getting additional compensation in the form of stock, is the "bargain element" received when you exercise. The bargain element is the difference between the exercise price and the market value of the stock at the time of exercising. For example, you may have a stock option that gives you the right to buy your employer's stock at $10 per share, while the actual price of the stock is $20. That's an immediate profit of 100% (not factoring in taxes).

Expiration Date

This is the date at which stock options expire. At some point, if you don't exercise your options you'll lose the right to buy the stock at the exercise price and the options disappear.

Types of Employee Stock Options

Non-Qualified Stock Options (NSOs)

NSOs are generally offered to non-executives or key persons of a company. Granting of NSOs is not a taxable event. Ordinary Income owed is at the time of exercise on the "bargain element" or the difference between the exercise price and the stock's current market price. When the stock is eventually sold, you pay capital gains taxes depending upon the amount of time you held the stock since exercising it. If held for less than one year you'll owe ordinary income tax and if held for longer than one year, you'll pay the more favorable long-term capital gains rate.

Incentive Stock Options (ISOs)

ISOs are generally offered to executives and key employees of a company. Granting of ISOs is not a taxable event and neither is exercising them. However, the dreaded alternative minimum tax (AMT) tax can apply to the "bargain element" of the exercised stock. When the stock is eventually sold, you pay capital gains taxes depending upon the amount of time you held the stock since exercising it. Like NSOs, if held for less than one year you'll owe ordinary income tax. But if held for longer than one year, you also must ensure it's been two years since the stock was granted to qualify for long-term capital gains.

How Do Stock Options Fit into My Financial Plan?

If you're fortunate enough to receive stock options as a benefit through your employer it's important to determine how they'll fit into your overall financial plan. In order to maximize their benefits, you have to consider taxes, the stock's value and the risk you're willing to take. (For related reading, see: 10 Tax Tips for Stock Options.)

Taxes

Taking advantage of long-term capital gains rates compared to ordinary income can help reduce the tax consequences of the stock options. That is if you're willing or able to open yourself to the potential risk of holding a concentrated position for a longer period of time. The difference between paying ordinary income tax and long-term capital gains can be significant, especially for individuals in the highest marginal income tax brackets. NSOs upon being exercised is recognized as ordinary income.

As a result, it can push individuals unknowingly into a higher tax bracket if their bargain element is great enough. Weighing the pros and cons of doing so is an important consideration to make when exercising NSOs.

ISOs can potentially expose you to AMT taxes, the parallel tax code. The way the IRS views ISOs is that they're essentially giving away the bargain element (the difference between exercise price and current market price of the stock) tax free. In order to ensure people pay taxes on that compensation, they include it in the AMT tax.

Stock's Value

When deciding whether to exercise stock options you want to determine the future prospects of the stock itself. If the current market value of the stock is similar to or less than the exercise price, you probably won't be exercising the option.

Depending on the expiration date of your options, you have time to wait and see how the stock performs. Remember, once the stock option is vested, you maintain the right to purchase the stock at the exercise price until the expiration date. If the stock performs better and rises above your exercise price, then you may consider exercising, especially if the long-term growth prospects are favorable.

Concentrated Stock Risk

With both types of stock options there lies a common risk. Stock option plans can create substantial wealth. What's important to understand is the risk involved when that wealth is created. Individuals can end up with concentrated stock positions from their company. Not only do they rely on the company for income, health benefits, etc., but a large portion of their net worth ends up in the company stock. If something were to happen to the company, it could be catastrophic for an individual with concentrated risk. The key is to diversify.

There is often an emotional connection to the stock. The company you've worked hard for has rewarded you with ownership and it's built you great wealth. It's a natural reaction. However, when it comes to investing you have to try and separate the emotional connections from what you're truly presented with as it relates to your financial plan and goals.

Whether the stock was bought using stock options or cash in a brokerage account, having a large portion of your net worth tied up in one stock represents a substantial risk. Diversification doesn't necessarily mean you'll earn less in return either when compared to a concentrated stock position. What it does mean is that your investment returns are being maximized for a given level of risk. Having a stock sell-off plan that manages the tax consequences in addition to diversifying over time is a key component of a financial plan that includes stock options.

Employee stock options can be a lucrative compensation perk. But they need to be understood to make the most of them. (For more from this author, see: What You Need to Know About Restricted Stock Units.)