The Coronavirus pandemic continues to make an indelible impression on the job market, and the volatility is unlikely to end anytime soon. Although unemployment remains high, we are also seeing growth in certain sectors, most notably in technology. Many of our wealth management clients have recently been offered new jobs and are in the midst of considering their employment-offer packages.
We’re also seeing that more and more companies are using restricted stock to motivate potential employees. Stock options mean that employees have the right to buy shares of company stock (public or private) at a set price, at a future date, as part of the employee’s compensation. The price of these shares cannot change, regardless of the current price of the stock when the employee purchases the shares, otherwise known as “exercising their option.”
There are two different types of stock options, and it’s critical to know which type you are being offered, because the tax effects are very different.
Nonqualified Stock Options: Many employers give employees non-qualified stock options (NSO), which are taxed twice. You pay ordinary income tax when you exercise your option, and you pay capital gains tax when you sell the shares.
Incentive Stock Options: Incentive stock options (ISO) are more efficient, from a tax perspective. ISOs typically result in fewer taxes paid because they are usually only taxed when you sell the shares, either as ordinary income or capital gains, depending on how long you have held the shares. These options can be quite valuable if your company goes public or gets acquired.
When you sign on with your new company, you will receive the enrollment guide and you should complete the enrollment paperwork shortly thereafter. At this point, you may want to work with a financial advisor to make sure you are contributing an appropriate amount to the stock plan.
Regardless of which type of stock option you hold, there are three basic strategies to consider in deciding when to exercise your option.
1. You may want to defer exercising your stock options if:
• The stock is performing well, and you want to let it appreciate.
• You do not have the cash to exercise and hold the shares.
• You want to postpone tax liabilities.
• You want to limit losses in case the stock goes down.
2. You may want to exercise your options and hold the shares if:
• Your stock options are about to expire, and you think the shares will continue to appreciate.
• Dividends on the stock are high and can offset part, or all, of the cost of borrowing to exercise your options.
• Your company requires you to hold a certain percentage of company stock.
• You want to get the clock ticking on the one-year holding period to qualify for long-term capital gains treatment on sale of shares.
3. You may want to exercise your options and sell the shares if:
• You need the money.
• You do not have the cash to exercise and hold the shares.
• You want more diversification in your portfolio.
• Your stock options are about to expire, and you need the cash.
• You think the stock price may go down.
The strategy you choose in exercising your options will determine the tax rates you will pay and when you will have access to the after-tax money.