Non-qualified stock options (NQSO’s) are, at times, given to employees as part of their overall compensation package. A stock option is the right to buy a stock at a specific price (exercise price) in the future. In brief, the idea behind NQSO’s is the hope of owning company stock at a discount to the current market price, therefore, creating additional value to you.
Let’s assume your employer XYZ, Inc. has given you 1000 NQSO’s on 1/1/2016; this is called the grant date. The grant will come with a price tag, also known as the exercise price, assume $50 per share. At this time there is no tax consequence to you since this is simply an award given to you by your employer to be filled at a later date.
Stock options are granted with a vesting schedule; vesting means you now have the right to exercise the stock options that you were granted at the exercise price. Typically, two types of vesting schedules are utilized most. The first is cliff vesting which means the options become 100% vested normallyafter three or five years, and the second is graded vesting, which can last up to six years but have equal vesting portions each year until the schedule is completed. Let’s assume your vesting schedule is graded vesting and it is set to vest 25% of the stock options in the first year. Fast forward to 1/1/2017 and now 250 shares of your NQSO’s are considered vested.
At this point, you are faced with the decision of whether or not to exercise your options on 250 shares of XYZ, Inc. stock. Continuing on with our current example, you decide to exercise on the same day you are vested, which is 1/1/2017. By exercising, you have essentially created what is called a bargain element, which is the difference between the exercise price and the current market price of the stock on the date of exercise.
- 250 shares * $50 (exercise price) = $12,500.
- 250 shares * $70 (hypothetical current market price on 1/1/2017) = $17,500
- Bargain Element: $17,500 – $12,500 = $5000 difference
The bargain element of $5000 will be taxed as ordinary income at this time. In other words, it will be w-2 income in the year of exercise. Once you have paid income tax on the options, the market price of the stock on the day you exercised ($70 per share) will become your cost basis. Once you have exercised the stock options you now have 250 shares of XYZ, Inc. it is your choice to either sell or hold the stock depending on your thoughts of where the stock will go. It is important to keep in mind that your holding period will begin on the date of exercise, (i) so if you decide to sell your shares before one year then the transaction will be treated as a short term capital gain or loss, (ii) if you hold your shares for one year or more the transaction will be treated as a long term capital gain or loss.
A tidbit of information to keep in the back of your mind throughout this process is the expiration date of the stock options. The expiration date is the date when the stock options expire if you do not exercise them. In the event the current stock price is below the exercise price ,then allowing the options to expire worthless is logical and will safeguard you from incurring any w2 income. If the current stock price is above the exercise price, then you would want to make sure to exercise the options at some point before they expire. Ultimately, the option expiration dates are important dates to consider as you evaluate option strategies to meet your financial & retirement goals.
Here’s a chart to help you visualize the flow of the process:
Once you have exercised your stock options you should consider what impact this new stock position in XYZ, Inc. will have on your overall asset allocation. Most likely this will cause a shift in allocation since you will now have increased your equity exposure relative to your bond investments and this should be considered as you evaluate overall portfolio risk. Digging deeper, you will also potentially be faced with company specific risk which reflects ownership in a specific company and therefore exposure to the individual company’s stock price. You can mitigate the potential downside of single stock risk by consulting with your Financial Advisor to rebalance and diversify your portfolio, bring your allocation to target and revisit your financial plan to make sure you are still on track with your goals.
Feel free to contact Katherine Sojo with any questions by phone 305.448.8882 ext. 243 or email: KSojo@ek-ff.com