HOW DO STOCK OPTIONS WORK FOR EMPLOYEES?

Employee stock options are a popular part of many companies’ compensation packages, offering employers a way to recruit and retain talent while aligning the interests of workers and shareholders.

For employees, stock options act as an additional form of compensation or bonus with the potential to increase in value as a company grows. This allows them to feel more connected to the company’s success as they can see their hard work pay off in the form of potentially rising stock prices over time.

Whether you're an employer looking to enhance your employee benefits package or an employee navigating the complexities of stock options, understanding how they work is crucial. This is especially true when dealing with various types of stock options, such as incentive stock options, nonqualified stock options, and even startup stock options that often carry unique terms.

In this guide, we’ll walk you through the details of how employee stock options work, the terms and concepts you’ll need to be familiar with, and the potential benefits and risks associated with them.

HOW DO EMPLOYEE STOCK OPTIONS WORK?

Generally, employees would be issued or “granted” stock options by their company as part of an employee stock option plan. This incentive stock option allows workers to purchase shares at a predetermined price, offering a potential financial benefit as the company’s stock price increases.

To better understand how stock options work, let’s first look at some common terminology.

• Grant amount: The number of shares you’re allowed to buy under the stock option plan
• Grant price: The fixed price you have to pay per share
• Issue date: The date that the grant was issued
• Expiration date: The date by which you have to purchase the stock, should you choose to
• Exercise date: The date on which you actually purchase the stock

Let’s look at a hypothetical example to see how this works.

You receive a stock option grant from your employer to buy 1,000 shares of your company stock on Jan. 1, 2024, at a market price of $20 per share. You are given until Jan. 1, 2039, to decide if you wish to exercise this grant. Then, on March 1, 2029, your company’s stock reaches $40 per share, so you exercise your option to purchase the stock at the original $20 per share.

In this case:

• Your grant amount is 1,000 shares
• Your grant price is $20 per share
• Your issue date is Jan. 1, 2024
• Your expiration date is Jan. 1, 2039
• Your exercise date is March 1, 2029

As you can see, one of the benefits of employee stock options is that you don’t have to commit to buying shares ahead of time. As the option holder, you have the right to buy shares upfront, but you’re not obligated to. If the market value never rises past the grant price, you don’t need to exercise your options, and if it does, you start with a profit.

EXERCISING STOCK OPTIONS

If you decide to exercise your options before the expiration date, you generally have two different ways to go about it: You can pay cash or do a cashless exercise, which is also known as a “same-day sale.”

In the example above, if you wanted to do a cash purchase, you would simply deposit funds in your stock options account to cover the cost of the shares – in this case $20,000 (the grant amount multiplied by the grant price). You would then own 1,000 shares of your company stock, which you could then sell or hold as long as you want.

For a cashless exercise, you could exercise your options and sell just enough to cover the cost of the purchase. Again, using the example above, you would exercise the option for all 1,000 company shares and sell half of them to cover the $20,000 purchase cost, leaving you with 500 fully paid-for shares.

Your brokerage firm can do these two transactions simultaneously, though it might charge a commission or processing fee.

THE TAX TREATMENT OF EMPLOYEE STOCK OPTIONS

There are two main types of stock options that companies award to their employees:

• Incentive stock option
• Nonqualified stock option

The main difference is how profits are taxed.

When you exercise NSOs, the difference between the grant price and the current fair market value that the shares are trading for is considered a profit, even if you don’t sell the shares. And that profit is treated as ordinary income for tax purposes, which means your employer will generally withhold federal and state income tax as well as Social Security and Medicare. In some company plans, these tax withholdings can even take place if you decide not to sell the shares.

This can create tax implications if the stock price drops below the grant price after exercise, potentially leaving you with a tax burden on profits that no longer exist. For example, if you exercise your NSOs but don’t sell the shares you receive, you will still be taxed on the “profits,” and if the shares then drop and trade below your grant price, you could end up paying taxes on money that you never actually received. Because of this possibility and the unavoidable income tax burden with NSOs, it’s typically recommended to leave NSOs in their option form and not exercise the option until you are ready to sell the shares. This often leads to a same-day sale (exercise and sell the options simultaneously). Same-day sales are the most common type of exercise transaction for NSOs. But everyone’s circumstances are unique, so it’s a good idea to work with a financial planner who has experience in managing corporate stock benefits.

In contrast, ISOs can have a more favorable tax treatment because they are not typically taxed when exercised. However, if you exercise and hold the shares for more than one year from the exercise date and two years from the original grant date, any profit is taxed as a long-term capital gain rather than ordinary income, which can result in lower tax rates for most people. It’s important to consider that during this “holding period” mentioned above, the stock price can go down and could result in an unfavorable financial loss. Again, it’s important to work with an experienced tax professional and financial advisor who can help you manage this process.

OTHER CONSIDERATIONS FOR EMPLOYEE STOCK OPTIONS

With most plans, if you leave your company, you have 90 days to exercise any vested stock options at their grant price. If you don’t, they will expire along with any unvested options. You already own any stock shares purchased through the employee stock option plan, so nothing changes there.

If you are an early employee, key contributor or a member of company management, you may also receive a large enough amount of stock options that the Alternative Minimum Tax could come into play. AMT, as its name implies, is an alternative method for tax calculation (see IRS form 6251) that ISOs with large gains can trigger. Triggering an AMT is sometimes unavoidable, but with good financial and tax advice along with a well-thought-out financial plan, it can be possible to avoid an AMT in some cases.

DIFFERENCES BETWEEN EMPLOYEE STOCK OPTIONS

Employee stock option plans are just one of the three common ways for companies to provide stock options to employees. The other two are employee stock ownership plans and employee stock purchase plans. Although the terms sound very similar, it is important to clarify the difference between these three plans.

EMPLOYEE STOCK OWNERSHIP PLAN

An employee stock ownership plan, also called ESOP, is a retirement plan similar to a 401k in which the company contributes to the plan in the form of its stock. The assets are held in a trust for employees, and they accrue shares in the plan over time.

As the employee/participant, you do not buy or hold the stock directly. You are typically only paid out upon either termination or retirement from the company, and you can choose to roll over the funds at that time or take the distribution (with tax implications). These are often attractive to companies due to being highly tax-advantaged and to help retain employees through potential long-term wealth and aligned goals.

EMPLOYEE STOCK PURCHASE PLAN

Employee stock purchase plans are a form of equity compensation in which employees can designate a regular payroll deduction to then purchase company stock. There are several rules associated with these plans, including who can participate, how much you can purchase and if the company chooses to discount the price at the offering period. Because these are not tied specifically to a retirement account, employees can choose to hold or sell the stock as they please; however, there are different tax incentives for holding it longer.

Although these can seem advantageous, we generally recommend that you don’t have more than 5% in any one stock, especially your employer’s stock, to help achieve diversification. In addition, being overconcentrated in one security can cause unnecessary volatility and risk with your retirement savings.

HOW MUCH TO INVEST IN COMPANY STOCK?

Be careful not to invest too much in company stock as your job and your retirement savings could be at risk. Over time, the company stock could become one of the biggest assets you own – perhaps more valuable than your 401k account and even more valuable than the house you own.

That is a problem – for two important reasons:

• Concentration risk: Professional money managers – those who manage mutual funds, pension funds, endowments and institutional funds – typically place no more than 5% of assets into a single stock. If you have a significant percentage of your net worth – say, 30% or more – in the shares of a single company, you are taking a risk that financial professionals would typically not recommend.
• Unemployment risk: One reason people lose their jobs is because their employer suffers a financial setback. So, at the very time the company’s stock is falling in value – possibly even to zero when it files for bankruptcy – you could find yourself out of work and the company assets you might need to rely on for financial help could be worth less or nothing.

Your ability to retire comfortably could be in jeopardy if you have invested a high percentage of your retirement account in company stock. Sudden unemployment and loss of retirement funds invested in company stock has happened to people who worked at major companies like Sears, Toys“R”Us, Bed Bath and Beyond, Enron and others. It was bad enough that their employees lost their jobs – but even worse, it hurt their retirement accounts at the same time. For that reason, we strongly recommend that you diversify to avoid putting too much money in a single stock.

Ideally, you should own many stocks because the returns of the stock market tend to be concentrated in a very small fraction of the market. If you hold only a few dozen stocks, you might miss out on those few big winners. Or worse, you could just end up owning only some of the losers.

The rules and specifics for every employee stock option program are company-specific, so it makes sense to get a copy of your company’s plan and study the details or hire a financial professional to review them for you.

If you have an employee stock option program or another equity compensation plan at your employer and you want to know more about how it can work as a part of your overall integrated wealth plan, call an Edelman Financial Engines planner today. We’re here to help.