Three things you should know about employee stock options

Compensation forms like r restricted stock units and performance shares, whereby executives receive a batch of shares in their companies after achieving a performance goal, have some key advantages over employee stock options.

They are simpler than stock options and the associated taxes are less complex and often better aligned with earnings. That said, employee stock options can be a key source of wealth for some households. That means that if options are part of your compensation package, it’s worth becoming familiar with how they work in general, as well as how your company handles stock options specifically.

Basics of Employee Stock Options

When employees receive stock option grants, they have the opportunity to exercise the options at a later date at a predetermined price, called the exercise price or exercise price.

Suppose Sharon received 100 shares of stock from her employer in 2014, when they were trading at $2.35 per share, with an exercise price of $10 per share and an expiration date of December 31, 2023. If the shares were trading at $20 per share when Sharon wanted to exercise her options towards the end of 2023, the options would be “in the money,” meaning the exercise price would be below the share price at the time of the exercise. Your profit would be the difference between your $1,000 strike price (your 100 stock options times the $10 strike price) and $2,000, the value of the stock at the time of exercise. You could continue to hold the stock after the exercise in the hope that it will rise, or sell it and pocket your profits.

Taxes? It depends

There are two key types of employee stock options: incentive stock options and non-qualified stock options. That distinction has a large impact on tax treatment, which in turn can affect the strategy used with options.

Nonqualified stock options (NSOs) are taxed at the investor’s ordinary income tax rate at the time of exercise.

In contrast, gains from incentive stock options (ISOs) are not taxed as ordinary income upon exercise (unless the ISO holder sells the shares at the same time). Instead, there is a tax benefit for holding the shares after exercise in order to qualify for the lower long-term capital gains rate on the profits from the sale.

However, to do so, the employee must meet two criteria: 1) he must have held the options more than two years after the grant date and 2) he must hold the shares more than one year after exercise.

Mitigate company-specific risk

As with restricted stock, employees with large option grants run the risk of having too much of their financial resources dependent on their companies. caring diversification advocates divesting the shares as soon as practical, weighing this against tax considerations and the valuation of the company (especially undervaluation).

One way to mitigate the risk of exercising options at precisely the wrong time is to exercise one portion of a grant at a time. very similar dollar cost averaging In a stock or fund, performing multiple exercises of multiple lots of options can help ensure that an employee exercises at a variety of prices. Exercising over a period of years rather than all at once will also allow the employee to spread the tax costs associated with the options. Again, it is helpful to obtain advice from a tax or financial advisor who is well versed in the options to determine the best course of action.

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This article was provided to The Associated Press by Morningstar. For more personal finance content, go tohttps://www.morningstar.com/personal-finance

Christine Benz is Morningstar’s director of personal finance and retirement planning.