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Must-Knows About Employee Stock Options

How to balance the tax and investment considerations.


As technology stocks ascended in the second half of the 1990s, employee stock options were the dominant form of equity compensation, with companies distributing them to rank-and-file employees as well as executives. But thanks to the combination of the dot-com bust and 2006 changes in the accounting rules that required companies to count stock options as an expense, other forms of equity compensation supplanted stock options as the employee equity compensation form of choice. Restricted stock units and performance shares—whereby executives receive a batch of stock from their companies after meeting a performance target—grew in popularity.

These forms of compensation have some key advantages relative to employee stock options. Near the top of the list? They’re more straightforward than stock options, and the associated taxes are less complex and often better aligned with gains. That said, employee stock options can be a key source of wealth for some households. That means if options are part of your compensation package, it’s worth your while to get familiar with how they work generally, as well as how your company handles stock options specifically. As with restricted stock, you’ll need to be aware of the vesting schedule and other details associated with your grant, and the tax issues can also be tricky. Thus, as with all forms of employer stock, consider seeking out objective advice about how best to manage both the investment and tax aspects of any stock options you receive.

Employee Stock Option Basics

When employees receive stock option grants, they have the opportunity to exercise the options at some later date at a predetermined price, called the strike price or exercise price. The option grant may vest over a period of time—for example, 25% of an options grant might vest in each year of four successive years—or all at once. As with restricted stock, an employer’s goal in granting options is to incentivize employees to stick around until they can exercise. The most common length of time between an options grant and the “exercise window”—the period during which the employee can exercise those options and buy the stock—is 10 years.

To use a simple example, let’s assume that Sharon received 100 shares of her employer stock in 2010, when it was trading at $2.35 per share, with a strike price of $10 per share and an expiration date of Dec. 31, 2019. If the stock were trading at $20 per share when Sharon wanted to exercise her options toward the end of 2019, the options would be “in the money,” meaning that the strike price is below the stock price at the time of exercise. Her profit would be on the difference between her $1,000 exercise price (her 100 stock options multiplied by the $10 strike price) and $2,000, the shares’ value at the time of exercise. She could either continue to hold the stock after exercise in the hope that it would go higher, or sell and pocket her profit.

Not all stock option grants yield a profit, however. For example, if Sharon received 100 shares of her employer stock with a strike price of $10 per share but the per-share price stayed between $7 and $8 during her exercise window, then her options are considered “out of the money” and she’ll be better off letting them expire. (She won't have a profit, obviously.)

Taxes? It Depends

In addition to understanding the key details of your options grant, including vesting schedule, strike price, and so on, it’s also important to be aware of the type of options you’ve received. There are two key types of employee stock options: incentive stock options, or ISOs, and nonqualified stock options, called NSOs. That distinction has a big impact on the tax treatment, which in turn may affect the strategy you employ with the options.

Nonqualified stock options are taxed at the investor’s ordinary income tax rate at the time of exercise. Going back to the preceding example, if Sharon’s options are nonqualified, the difference between her strike price and her exercise price (the so-called “bargain element”) is taxed as ordinary income at the time of exercise. Taxwise, that gain counts as compensation, so employers typically withhold all of the taxes they would on your regular salary: federal and state income tax as well as Social Security/Medicare tax. From a practical standpoint, it’s common for employees with options to elect a “cashless exercise,” selling enough shares at the time of exercise to cover the cost of the shares and the related tax bill. Employees come away with fewer shares, but the benefit is that they don’t have to front the cash needed to exercise the options.

Incentive stock option gains, by contrast, aren’t taxed as ordinary income at the time of exercise (unless the ISO holder sells the stock at the same time). Instead, there’s a tax benefit to holding the stock after exercise in order to qualify for the lower long-term capital gains rate on the profits from the sale. In order to do so, however, the employee must meet two criteria: 1) they must have held the options more than two years beyond the grant date and 2) they must hold the stock more than one year after exercise. To go back to the preceding example of stock options that were “in the money” (with a strike price of $10 and an exercise price of $20), let’s assume Sharon exercised her stock options and hung on to the stock for another 18 months following her exercise, at which time she sells it for $30 per share. In that case, she’d be eligible for the long-term capital gains rate on the difference between her cost basis—$10 per share—and her sale price of $30 per share. A key detail, however, is that for all of her stock profit to be eligible for long-term capital gains treatment, she’d need to pony up for the $10 per share exercise amount using external funds. If she needs to sell some shares to exercise her options, at least a portion of her gains will be taxable as ordinary income.

As if all of this weren’t complicated enough, the Alternative Minimum Tax, or AMT, can come into play with incentive stock options. However, thanks to changes in the tax code that went into effect in 2017, it’s less likely that taxpayers who exercise ISOs will pay the AMT than was the case five years ago. In a nutshell, the AMT is a parallel tax system that was originally designed to ensure that wealthy Americans pay their fair share of taxes. Taxpayers calculate their tax bills on the regular tax system as well as the AMT system, then pay whichever amount is higher. Under ISO treatment in the AMT system, the difference between the grant price and the exercise price is taxable as income at the time the options are exercised (but not sold), even though that’s not the case with the regular tax system. That opens up the possibility—which became very real for many technology-sector employees during the dot-com bust—that someone could owe taxes under the AMT even if they didn’t have an actual gain in the stock. But again, with the AMT affecting so few taxpayers today, it won’t be a major factor for most ISO holders presently.

Mitigating Company-Specific Risk

Considerations related to employee stock options aren’t limited to taxes: Investment considerations are just as important. As with restricted stock, employees with hefty options grants risk having too much of their economic wherewithal riding on their companies. Minding diversification argues for divesting the shares as soon as is practical while balancing that against tax considerations and the company’s valuation (especially undervaluation). For example, if a company’s shares happen to be exceedingly cheap and/or the employee can qualify for long-term capital gains treatment on ISOs by holding, it might make sense to continue to hold the stock after exercise, even though diversification would argue for cutting them loose. In the case of NSOs, however, the case for dumping the shares at the time of exercise is strong, because there’s no tax benefit to hanging around. (Extreme undervaluation in the stock is the only real argument for holding tight in that instance.)

It’s also worth noting that decisions related to an options grant aren’t all or nothing. One way to mitigate the risk of exercising options at precisely the wrong time is to exercise a portion of a grant at a time. Much like dollar-cost averaging into a stock or fund, conducting multiple exercises of multiple lots of options can help ensure that an employee exercises at a variety of price points. Exercising over a period of years rather than all in one go will also enable the employee to spread out the tax costs related to the options. Here again, it’s helpful to obtain advice from a tax or financial advisor who’s well-versed in options to determine the best course of action.

A version of this article appeared on July 22, 2021.

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The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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About the Author

Christine Benz

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Christine Benz is director of personal finance and retirement planning for Morningstar, Inc. In that role, she focuses on retirement and portfolio planning for individual investors. She also co-hosts a podcast for Morningstar, The Long View, which features in-depth interviews with thought leaders in investing and personal finance.

Benz joined Morningstar in 1993. Before assuming her current role she served as a mutual fund analyst and headed up Morningstar’s team of fund researchers in the U.S. She also served as editor of Morningstar Mutual Funds and Morningstar FundInvestor.

She is a frequent public speaker and is widely quoted in the media, including The New York Times, The Wall Street Journal, Barron’s, CNBC, and PBS. In 2020, Barron’s named her to its inaugural list of the 100 most influential women in finance; she appeared on the 2021 list as well. In 2021, Barron’s named her as one of the 10 most influential women in wealth management.

She holds a bachelor’s degree in political science and Russian language from the University of Illinois at Urbana-Champaign.

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