Many companies now offer employees the opportunity to own company stock. In fact, about 36% of the work force owns stock in their employers.
Stock options can be a great benefit for both the employer and the employee. Employees get additional benefits, and companies attract and retain valued employees who are invested in the company.
Stock ownership might be through a stock purchase plan, stock options, or company sponsored plans where the company hold stock in the employer for the employee (employee stock ownership plans). Let’s take a look at the options and differences, and what they might mean for your financial plan.
What is a Stock Option?
To begin, let’s talk about what a stock option is. A stock option is the ability to buy a stock at an agreed upon price with a certain period of time. So in this case, an employer gives the employee the ability to buy company stock at a certain price (usually at a discount), within a certain period of time.
The Ins and Outs of Stock Options
A company will grant the employee the option of buying the stock at a certain price. This price is called the grant or strike price. When you exercise your option to buy, you let the company know you want to buy the stock options.
When you look into using your stock options, you’ll want to review your option agreement, or the document that tells you the details of your options. It will tell you if you receive a discount on the price when you buy the stock.
The option agreement will tell you whether or not you have restricted stock units. When you have restricted stock units, the company will grant you stock options after you’ve met their requirements. For example, the shares might vest over a period of four years with the company.
The option agreement will also detail what type of stock options you have. There are two common types, nonqualified stock options and incentive stock options. Each type has different tax consequences.
Nonqualified Stock Options
These stock options are the most common. With these options, the stock can be offered at a discount to the stock market’s value. However, you are required to ordinary income tax on the difference between the grant price and the stock’s market value (“the spread”) when you purchase (“exercise”) the shares.
These stock options can also be transferred to children and charities depending on company policy.
Incentive Stock Options
These are typically less common as they are typically offered to top executives. With incentive stock options, no income tax is due when you are granted (offered) or when you exercise (purchase) the option. Instead, the tax is deferred until you sell the stock. When you sell, the stock is taxed at the capital gains rate rather than as ordinary income.
There are some restrictions when you can grant and exercise incentive stock options, and the sale can have complicated tax consequences. But for high earning corporate executives, incentive stock options often offer considerable tax savings.
A Real Life Example
Let’s work through a real life example to help you understand the process from beginning to end.
Say Jane works for XYZ Company, and XYZ grants its employees options to buy 100 shares at $10 in six months.
In six months, the XYZ’s stock is worth $15. Jane decides to go ahead and exercise her option by buying the stock at $10 when the six months is up. She’s allowed to sell the stocks right away, so she sells the stocks at $15 even though she paid $10 for them. The spread, the $5 for each stock for 100 stocks, totals $500.
comSince she has nonqualified stock options, this $500 is taxed at her ordinary income tax rate.
The Complexities of Stock Options
Knowing exactly what the right thing to do with your stock options isn’t easy. For one, there are more ways to purchase your employer stock than simply plunking down the cash. You can swap company stock you already own, and you can also use a “cashless exercise” where you buy and sell with a stockbroker simultaneously.
It’s also a bit tricky to know exactly when to exercise your option. If you expect the stock to go up in price, you might like to wait as long as possible to exercise the option, as you’ll get the largest gain. However, you might also like to sell as quickly as possible to limit your exposure to your company. If you think your employer is headed for trouble, you’ll want to sell the stock.
(Of course, this gets into actively trying to manage investments which might not be a great idea for average investors.)
Even if you like the direction your company is going, it’s important to not own too much company stock to be properly diversified. Your income already depends on the company. You don’t want your entire investment portfolio to also be tied to one company’s prospects.
You’ll also want to consider the tax consequences of your decision. It might make sense to buy and sell over time to space out the additional income. It’s a complex decision. Consult with a professional to figure out the best way to use your stock options to their full advantage.