Non-qualified stock options are a benefit often provided to employees as part of their compensation package. If you’ve received a grant, there may be a nice profit if your employer’s stock increases in price. This, of course, is not guaranteed. There are many moving parts to a non-qualified stock option grant. To recognize the most meaningful value, you must understand non-qualified stock options and how they can impact your tax situation.

What is a stock option?

Stock options are a form of compensation used to attract talent, reduce turnover, and incentivize employees. There are three types of stock options: restricted stock units (RSUs), which you can learn more about in our post Have a plan to manage your Restricted Stock Units (RSUs) to Improve your long-term financial success, incentive stock options (ISOs), which will be a future blog post, and, non-qualified stock options. 

Non-qualified stock options 

There are 4 critical pieces of information about non-qualified stock options (known as NQOs, NSOs, or NSQOs) you need to be aware of:

1. GRANT DATE: The date the stock options are given to you. 
2. EXERCISE PRICE: The strike price or grant price is the price per share you’ll pay for the stock. The price is determined by the fair market value (FMV), or a discount on the FMV, on the grant date.
3. VESTING SCHEDULE:  This is when you can exercise your options. 
4. GRANT EXPIRATION DATE: Non-qualified stock options, like milk, have an expiration date. You lose the stock options if you have not exercised them by expiration. If you quit or retire, you’ll have a specific amount of time to exercise your vested NQOs. If you don’t exercise, you’ll lose them. All non-vested options will be lost on all but rare occasions.

Example

Your employer, LMNOP, granted you 10,000 shares on December 15, 2022 (grant date). The shares have a 4-year vesting schedule, which means on December 15, 2023, 20224, 2025, and 2026, you can exercise 25%, or 2,500 shares, on or after each date. The grant expiration is in 10 years, on December 15, 2032. The exercise price is the market value of LMNOP on December 15, 2022, $10 per share.

Receiving the grant is a non-taxable event. You don’t owe any tax, nor are you required to report anything. This means your employer has given you the right to buy a specific number of shares at a set price in the future.

Non-qualified stock options vest

December 15, 2023, and your first non-qualified stock options have vested. You now have the right to exercise (or buy) 2,500 shares of LMNOP. You’re not required to, but you can exercise on any date after your NQOs vest until the grant expiration. When your shares vest, no taxes are still due, nor do you need to report anything.

Now is the point when NQOs start to get complicated. You have decisions to make, and those decisions have financial repercussions. The first question is, when should you exercise the options?

Easiest Decision: If the stock price is less than your exercise price, your option’s value is zero and is considered underwater. 

For example, 2,500 shares of LMNOP have vested, and the current stock market price is $5.00 per share. Remember, your exercise price is $10 per share. The shares are underwater, and you won’t buy them for $10 per share when their value is currently $5 per share.

IN THE MONEY: If the stock price exceeds the exercise price, the option is in the money. 

For example, if your 2,500 shares of LMNOP are $20 per share and your exercise price is $10 per share, the option is in the money. 

Exercising your non-qualified stock options 

Taxation begins when you exercise an NQO. The difference between market value and exercise price, called the bargain element, is considered ordinary income. That bargain element is taxed as compensation subject to federal income tax, Social Security tax, and Medicare tax withholding. It will be reported on the W-2 for the year of exercise. 

Continuing with our “In the money” example, let’s say your 2,500 shares of LMNOP are $20 per share, and your exercise price is $10 per share. If you choose to exercise your 2,500 shares, you’ll have a bargain element of…

 (2,500 shares x $20 current market value) – (2,500 shares x $10 exercise price) = $25,000, which will be taxed as earned income.

As you can see, the more significant the difference between the exercise price and the shares’ current value, the higher the tax bill. Paying that tax bill can be challenging. Thankfully, most companies allow a cashless exercise in which you can sell enough shares back to your employer to cover the tax bill. 

Voilà now you own stock

After you exercise your non-qualified stock option, the next taxable event occurs when you decide to sell the shares you’ve exercised. The cost basis of the stock is the exercise price plus any brokerage fees and commissions. When the stock is sold, you’ll report a capital gain (or loss) for the difference between the gross proceeds from selling the stock minus the stock’s adjusted cost basis. Once exercised, you have three options:

1. Sell Immediately: If you sell at the same time you exercise your newly vested shares, you will not have any capital gains (or losses) and, therefore, will not pay additional tax.
2. Sell less than 1 year: If you exercise your shares and hold them for less than one year, and there you’ll be subject to short-term capital gains, which are taxed at higher ordinary income tax rates. 
3. Sell later than 1 year: If you sell your shares at least a year after being exercised, they will be classified as long-term gains, and you’ll be subject to the long-term capital gains tax rate, which is usually lower than the short-term capital gains tax rate. 

Keep in mind there is no time limit. The shares are now yours, and you can hold the stock until the cows come home. When you decide to sell is based on your needs, tax considerations, and the stock’s price. Over time the value of the shares will fluctuate with the markets. There is investment risk.

The best answer is one that is customized to you and your needs. A detailed financial plan and liquidation strategy can help determine the best action.

Managing Your Non-qualified Stock Options

There are three often competing goals of stock options:

1. Minimize tax liability: If you’re receiving NQO grants, you’re probably a high earner and, therefore, in a higher tax bracket. Exercising your options could create some less-than-ideal tax situations. 
2. Maximize value: On the other hand, some decisions must be made to maximize the options’ value. You’re at the mercy of your employer’s stock price, economy, financial outlook, and of course, the grant’s expiration date. You don’t want to have worthless options. 
3. Concentration risk: This risk occurs when you have a large amount of your net worth and income tied to your employer. Typically, you shouldn’t have more than 10% in your employer’s stock. Large grants make this target difficult to achieve, but having a financial plan and a liquidation strategy can help.

A stock options strategy must be a part of your comprehensive financial plan. Not taking the time to plan today may prevent you from achieving your stock option goals. Providing specific do this, don’t do that advice for NQOs is pointless. First, every company and stock price history is different. Second, every individual has various financial circumstances. It’s like a Rubik’s cube of possibilities. Several strategies, some quite complicated, are available to you when exercising your options.

The key to non-qualified stock options is knowing the vesting, expiration, and taxation rules. Then you have to integrate them into an overall comprehensive financial plan. Proper planning increases the chances of receiving the most significant value with the lowest taxes.

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