Understanding the Basics of Stock Options

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June blog image

Have you heard those stories about startup founders striking it rich after their company went public? Turns out, stock options can be a pretty sweet deal even if your company doesn’t make it big. They’re a key part of compensation and can potentially bring in a windfall down the line. But there are different types of options to keep in mind, each with its own rules and tax nuances. Let’s break it down.

Restricted Stock Units (RSUs)

If you have RSUs, you know that they are a form of stock-based compensation that companies give out to inspire loyalty – you win when they do. Typically, you get awarded shares, but don’t get to enjoy voting rights or dividends until a vesting schedule kicks in. The company might also limit when you can sell or transfer these shares. Once you’re vested, you’ll want to think about keeping or selling them, depending on many different factors including the financial health and stability of the company. Keep in mind that the shares you receive will be reported as ordinary income. If you sell them later at a higher price, that gain is also taxable. Also, holding the shares for less than a year triggers taxation at the same rate as your income tax (up to 37% in 2023 for some) but if you hold on for a year or more, the long-term capital gains rate applies (which is maxed out at 20% in 2023).

Incentive Stock Options (ISOs)

ISOs are another way companies incentivize employees by offering stock-based compensation which gives you the right to purchase the stock at a specific price for a ten-year period. The price is usually based on the stock’s value on the day the option is issued. ISOs can be exercised once they are vested, which may take up to six years. If exercised, they are hoped to provide you with a gain if the underlying stock increases beyond the strike price. It’s essential to hold onto your ISOs for at least two years from the grant date and the stock must be held for at least another year once the options are exercised for the best tax treatment.

Non-Qualified Stock Options (NQSOs)

NQSOs and ISOs are similar, but there’s one big difference – NQSOs don’t come with the same tax benefits as ISOs. Both let you buy company stock at a set price within a certain timeframe and usually have a 10-year expiration. But when you sell stock bought through an NQSO, you’ll be taxed at your regular income rate instead of the lower capital gains rate.

Understanding how taxes impact gains from stock options depends on the type of option and your overall income and tax circumstances. It’s crucial to note that some options could trigger the alternative minimum tax (AMT). Before you exercise an option or sell stock derived from it, seek advice. At Method Financial Planning, we empower our clients with the necessary insights for prudent decision-making in their financial planning. Have questions? Just ask. We’re here to help.

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