Exercise Stock Options: Everything You Need to Know

There are three main forms of taxes that must be considered when exercising an ISO: The cost basis and holding period in the old shares carry over to the new shares. You decide to exercise your option. Keep in mind that exercising stock options can be complicated, and result in significant financial and tax consequences. First, NSOs are offered to non-executive employees and outside directors or consultants.

Here are some strategies to consider if you are have stock options: A cashless exercise in which vested options are exercised at a predefined price or expiration. A cashless hold is when you exercise enough options to purchase the remaining shares without using additional cash.

Strategies

And they may be right, under most circumstances. There are times, however, when exercising your options early is a good idea. Here are four reasons to consider exercising your options before the expiration date:. You currently own, or hold options on, too many shares of company stock than is healthy for your overall investment portfolio.

You believe the stock is a good investment for the long term and you want to buy as many shares as you can afford. Your financial gain from exercising your options all at once would push you into a higher tax bracket, so you are spreading out your stock purchases under the option agreement. Remember that there are tax implications to exercising your stock options. More on tax considerations below.

You purchase your option shares with cash and hold onto them. This gives you the maximum investment in company stock, providing you with potential for gains from increases in stock value and payment of dividends if any.

You may need to deposit cash into your brokerage account or borrow on margin to pay for your shares. You will also likely pay brokerage commissions, fees and taxes.

You purchase your option shares and then and immediately sell them. In many cases, your brokerage will allow this transaction without using your own cash, with the proceeds from the stock sale covering the purchase price, as well as the commissions, fees and taxes associated with the transaction.

This choice provides you with cash in your pocket to put into other investments or use as you otherwise see fit. You exercise the option and then immediately sell just enough shares to cover the purchase price, commissions, fees and taxes. Your resulting proceeds will remain in the form of company stock.

A stock swap is another form of cashless stock option exercise. With a stock swap, you exchange company shares that you already own to pay for the shares obtained through the exercise of your stock option. The main benefit to this choice is avoidance of taxes. Keep in mind, however, that you must hold the shares used in the exchange for a stated period of time typically one or two years in order to avoid the transaction being treated as a sale and incurring tax costs.

Tax implications will play a key in role in your decisions on when and how to exercise your stock options. Remember, poor choices can have a devastating effect on your financial well being. Always consider consulting with a tax expert before exercising any stock option. The IRS recognizes two types of stock options: Options granted through an employee stock purchase plan or incentive stock option ISO plan are considered statutory stock options.

Tax Considerations for Incentive Stock Options. There are three main forms of taxes that must be considered when exercising an ISO: When you exercise your options and purchase your shares at a fair market value higher than the grant price, but do not immediately sell your shares, you will likely be required to pay a federal AMT, and possibly a state AMT. In regard to long-term capital gains taxes, consider that you will pay a more favorable long-term capital gains tax rate if you exercise your options, hold the shares for more than a year, and then sell your shares more than two years after the option grant date.

You then hold these shares for at least one year before selling them and pay taxes at the combined federal and state marginal long-term capital gains tax rate of The AMT will be credited against the taxes you owe when you sell your exercised stock earlier. Alternatively, if you believe that your company's stock will appreciate rapidly, it may be worth exercising your stock options early and paying the higher tax rates.

The result may be to accumulate a great deal of wealth from owning a larger piece of a profitable company. There are many examples of employees at startups, like Instagram, who became millionaires overnight from their stock options alone. Financial decisions can be extremely complicated, even for the most experienced investor.

Make sure that you understand all of the legal and tax implications involved before before exercising your stock options. You can begin the process by discussing your situation directly with the legal professionals on UpCounsel's marketplace. UpCounsel gives you access to some of the nation's best lawyers from top law schools like Yale and Harvard. Get all the facts you need first, so you'll be in a position to make the best decisions about your financial future.

Thanks for using UpCounsel! To begin, employees are typically not granted full ownership of the options on the initiation date of the contract, also know as the grant date.

They must comply with a specific schedule known as the vesting schedule when exercising their options. The vesting schedule begins on the day the options are granted and lists the dates that an employee is able to exercise a specific number of shares. For example, an employer may grant 1, shares on the grant date, but a year from that date, shares will vest, which means the employee is given the right to exercise of the 1, shares initially granted.

The year after, another shares are vested, and so on. The vesting schedule is followed by an expiration date. On this date, the employer no longer reserves the right for its employee to purchase company stock under the terms of the agreement.

An employee stock option is granted at a specific price, known as the exercise price. It is the price per share that an employee must pay to exercise his or her options. The exercise price is important because it is used to determine the gain, also called the bargain element, and the tax payable on the contract. The bargain element is calculated by subtracting the exercise price from the market price of the company stock on the date the option is exercised.

The Internal Revenue Code also has a set of rules that an owner must obey to avoid paying hefty taxes on his or her contracts. The taxation of stock option contracts depends on the type of option owned. Although the timing of a stock option strategy is important, there are other considerations to be made. Another key aspect of stock option planning is the effect that these instruments will have on overall asset allocation.

For any investment plan to be successful, the assets have to be properly diversified. An employee should be wary of concentrated positions on any company's stock. While you may feel comfortable investing a larger percentage of your portfolio in your own company, it's simply safer to diversify. Conceptually, options are an attractive payment method.

In practice, however, redemption and taxation of these instruments can be quite complicated. Most employees do not understand the tax effects of owning and exercising their options. As a result, they can be heavily penalized by Uncle Sam and often miss out on some of the money generated by these contracts.

Remember that selling your employee stock immediately after exercise will induce the higher short-term capital gains tax. Waiting until the sale qualifies for the lesser long-term capital gains tax can save you hundreds, or even thousands. What's an Employee Stock Option? Grant Date, Expiration, Vesting and Exercise To begin, employees are typically not granted full ownership of the options on the initiation date of the contract, also know as the grant date.

Taxing Employee Stock Options The Internal Revenue Code also has a set of rules that an owner must obey to avoid paying hefty taxes on his or her contracts.

For non-qualified stock options NSO:

What Does It Mean to Exercise a Stock Option?

Exercising stock options can be complicated. Exercise early? Wait to exercise? Do a cashless exercise? Arm yourself with the knowledge of when you can access your shares, how you can exercise your options and the tax implication of selling strategies. Get The Most Out Of Employee Stock Options. if an employee is granted shares of Stock A at an exercise price of $25, Although the timing of a stock option strategy is important. John Olagues, author of Getting Started in Employee Stock Options, talks about advanced employee stock option exercise strategies. John is a former Stock Options Market Maker from the Chicago Board Options Exchange and the Pacific Options Exchange in San Francisco.