Stock options have been growing in popularity as an addition to employee compensation packages. If you are lucky enough to have an employee stock option plan, the rewards are substantial and could fund many of your financial goals. However, to get the most out of your employee stock options, it’s important to understand how they work and how they’re treated for tax purposes.
What Are Employee Stock Options?
An employee stock option is a contract from the company you work for that allows you to purchase a certain number of shares of your employer’s stock at a specific price over a set period of time. The most common forms of employee stock options are Non-Qualified Stock Options (NSO) and Incentive Stock Options (ISO).
The primary difference between the two is that NSOs are usually offered to more people, including non-executive employees or even outside directors. ISOs, on the other hand, are typically reserved for high-level executives. ISOs get special tax treatment by the IRS, whereas NSOs do not.
Pay Taxes Now
Minimizing your liability when you invest in stock options is a big part of making the most of this employee benefit. Pay some taxes now to diversify your portfolio and reduce your overall risk. By paying taxes upfront, you decrease capital gains rates in the future.
There are some risks to this strategy, though. If the price of the stock plummets, you may pay more in taxes than the value of the stock. However, if the exercise price is low, the company’s prospects are good, and there are very few out-of-pocket costs at the time of exercise, paying taxes upfront can be a good strategy.
Max Out Your Retirement Plan
It’s usually never a good idea to own more than 10% to 20% of any single stock. While this general rule may be hard to follow with large stock option grants, you can still aim for this number. One way to do that is by selling enough shares each year to max out your retirement account contributions and possibly even your spouse’s, as well. Per the IRS, as of 2020, the 401(k) contribution limit is $19,500, with a catch-up limit of $6,500.
Set a Date To Sell by Each Year
Many people, especially executives, get more grants each year. Even if they sell stock annually, their balance may still increase over time. Help reduce your risk of owning too much stock by setting a date by which you will sell it each year, regardless of whether the market is up or down. If you’re selling a large amount of stock, you may want to try to break up the amount over the course of several weeks so that you can better avoid bad days, especially if the market is highly volatile.
Making the most of your employee stock options requires careful tax planning over a period of years. With meticulous preparation and a well-thought-out strategy, you can manage the risks and maximize the benefits of your employee stock options.