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Over the years, employee stock options have become an increasingly common way to recruit higher-ranking employees and give them a sense of ownership in a company. According to the National Center for Employee Ownership, the number of workers holding options has grown nine-fold since the late 1980s.

Indeed, stock options, which give you the right to buy shares at a pre-determined price at a future date, can be a valuable component of your overall compensation package. But to get the most out of them, it’s important to understand how they work and how they’re treated for tax purposes.

Understanding the Basics

The benefit of a stock option is the ability to buy shares in the future at a fixed price, even if the market value is higher than that amount when you make your purchase. Your ability to exercise your options is determined by a vesting schedule, which lists the number of shares an employee can purchase on specific dates thereafter.

An employer may grant you 1,000 shares on the grant date, for example, with 250 shares vesting one year later. That means you have the right to exercise 250 of the 1,000 shares initially granted. The year after, another 250 shares are vested, and so on. The vesting schedule also includes an expiration date. That’s when the employee no longer has the right to purchase company stock under the terms of the agreement.

The price at which the employee can purchase shares is known as the exercise price. In most cases, it’s simply the market value of the stock on the grant date. If the stock price goes up by the time you vest, your option is considered “in the money,” meaning you can buy the shares at a lower price than they’re now worth.

Types of Stock Options

There are two main types of employee stock options – non-qualified stock options (NSOs) and incentive stock options (ISOs). One difference between them is eligibility. Companies can grant the former to employees, consultants and advisors; however, only employees can receive ISOs.

But the biggest distinction is how they’re treated for tax purposes at the exercise date.

In the case of an NSO, you incur a bill right when you exercise the option. The difference between exercise price and fair market value of the shares is subject to ordinary income taxes in that year.

Let’s say you have options with an exercise price of $10 a share that rose to $30 by the time you exercised them. You’d pay income taxes on $20 per share.

When you subsequently sell the shares, any further increase in the sale price is subject to the more favorable capital gains rate. Suppose they rose in value to $55 a share when you sold them two years later. You’d pay the long-term capital gains rate on $25 per share (though you’d pay the higher short-term rate if you sold them within a year of their purchase).

ISOs are usually seen as more advantageous for the employee, in part because the exercise date isn’t a taxable event (though higher-earning employees have to make an alternative minimum tax, or AMT, adjustment based on the difference between the current market price and the exercise price).

Instead, you settle up with the IRS when you actually sell your shares down the road. If you’ve held the stock for more than a year, you’ll incur the long-term capital gains tax on the difference between the exercise price and the eventual sale price. So if we use the same prices in the earlier example, you’d pay the capital gains tax on $45 per share ($55 sale price minus the $10 exercise price).

In order to get to get the preferred tax treatment, ISOs must be held for two years from the date they are granted and at least one year from the exercise date. Otherwise, a “disqualifying disposition” occurs, and the difference between the grant price and market value on the exercise date is subject to ordinary income tax.

Mind the Expiration Date

Stock options don’t last forever. Typically, there’s a vesting schedule that lasts anywhere from one to four years, though some employees may have up to 10 years. And if you leave the company for whatever reason – whether it’s because of a layoff, resignation or retirement – you may only have 90 days to use them.

If you have in-the-money options at your disposal, it behooves you to act well before the expiration date. Some employees simply forget about the deadline, or wait on their decisions as long as possible in the hope that the price will go up higher still. That strategy can backfire, however.

If you’re within a few weeks of the expiration and the stock is trading above the exercise price, it’s probably time to act. The last thing you want to do is let the options expire and be worthless.

Keep Your Portfolio Diverse

A generous stock option benefit is certainly nothing to complain about. But it does have a significant risk – the possibility that too much of your wealth will be tied up in a single stock.

As a general rule, you want to avoid having more than 10% to 15% of your portfolio tied to a specific company. Should the organization fall on hard times, you would not be diversified enough to cushion the blow.

If you’re crossing that threshold, you might think about selling enough stock each year to keep your nest egg safe from excess volatility risk. To account for fluctuations in the market, consider dividing the sale into a series of transactions over a few weeks or months – especially for larger amounts. You can then use that income to increase your 401(k) and IRA contributions.

The Bottom Line

Employee stock options can be a valuable part of your compensation package, especially if you work for a company whose stock has been soaring of late. In order to take full advantage, make sure you exercise your rights before they expire and understand the tax effect of your decisions.

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