Exercising Stock Options - An Investment Guide

Stock options have gained significant traction as a preferred form of employee compensation in recent years, offering a unique way to align employee interests with company performance. These options grant employees the right to purchase company shares at a predetermined price, often referred to as the “strike price,” at a future date. By tying compensation directly to the company’s success, stock options incentivize employees to adopt an ownership mindset, driving innovation and efforts to boost profitability. However, understanding their complexities, including exercising stock options, their tax implications and potential risks, is important. To make informed decisions and maximize the benefits of your stock options, consider consulting with a financial advisor who can provide personalized guidance tailored to your financial goals.

What Is a Stock Option?

Stock options are a popular form of long-term compensation used by companies to attract, retain and incentivize employees. By aligning the financial interests of employees with those of the company, stock options encourage employees to contribute to the organization’s growth and success. These options are typically granted based on an employee’s rank within the company, their tenure or as part of a negotiated benefits package.

Stock options give employees the right, but not the obligation, to purchase company stock at a predetermined price, known as the strike price or grant price. This price is typically set at the stock’s market value at the time the options are issued. Employees benefit when the company’s stock price increases, as the value of their options rises correspondingly.

The profit from stock options is realized when the employee sells the shares after exercising their options. The gain is calculated as the difference between the stock’s current market price and the strike price.

For instance, say you’re granted 100 stock options with a strike price of $5 per share. If the company’s stock price increases to $20 per share, you can exercise the options and sell the shares for a profit of $15 per share. In total, you would earn $1,500 (100 shares x $15 profit per share).

It’s important to note that these profits are considered taxable income. Employees must report their earnings on their tax returns, and the type and timing of taxation depend on the type of stock options granted (e.g., incentive stock options vs. non-qualified stock options).

How Vesting Schedules Work

To ensure employees remain with the company and contribute to its long-term success, most organizations implement a vesting schedule for stock options. Under a vesting schedule, employees earn the right to exercise a portion of their options over a specified period.

For example, an employee granted 100 stock options with a four-year vesting schedule might receive 25 options at the end of each year. At the end of year one, 25 options would be vested and eligible for exercise, while the remaining 75 would continue to vest over the subsequent three years.

If the employee leaves the company before all the options are vested, they forfeit any unvested options. This forfeiture provision protects the company from granting significant benefits to employees who depart prematurely.

How to Exercise a Stock Option

When you exercise stock options, you convert your options into actual shares of the company. You can keep the shares as part of your investment portfolio or you can choose to sell them. Some people keep some shares and sell the others.

Your stock options will have a vesting date. Again, as we discussed above, they can vest all at once or over a period of time. Once you are past the vesting date, you can choose when to exercise your options based on the stock price, tax deadlines or any other reason.

To exercise your stock options, you must contact your company’s stock option manager. For most companies, you will have a stock option portal to log into and manage your stock options. In this portal, you can see each of your stock option grants, the strike price, vesting schedule and how many shares are vested versus unvested.

Stock Option Exercise Methods

When logging into your stock option portal, you should have four options to choose from with your 100 stock options:

Exercise-and-hold transaction. Purchase your shares of stock by paying cash for the option cost, brokerage commissions and any fees and taxes owed. You now own all 100 shares. This strategy is best for investors who are bullish on the company’s future and have cash to cover the costs.
Exercise-and-sell-to-cover transaction. Sell enough shares to cover the option cost, commissions, taxes and fees. You will own fewer than 100 shares and may receive a residual amount in cash. This strategy is ideal for investors who are bullish on the company, but who do not want to use their cash to complete the transaction.
Exercise-and-sell transaction. All shares are sold and the investor receives cash after paying all costs. You will receive zero shares from this transaction. Investors use this strategy when they feel the stock is overvalued or when they want to diversify their holdings.
Hold your stock options. Wait to exercise until the stock options increase in value. This is best for options that are less than the strike price (“underwater”) or when the expiration date is many years away.

For Employees Leaving the Company

Many companies provide a post-termination exercise (PTE) period so that you do not lose your options when your employment ends. This process allows retired, laid off or terminated employees time to exercise their options within a specified timeframe. These former employees can exercise their stock options in the same manner as a current employee.

The PTE period varies from company to company. Some companies offer just three months, while more generous companies allow up to seven years or for as long as you worked at the company.

Only vested options are eligible to be exercised during this period. Any unvested options are forfeited.

How Exercising Stock Options Affects Your Taxes

Stock options are taxed as ordinary income when they are exercised. Your taxable income is based on the difference between the market price and the strike price. If you sell the shares at a later date, any profits will be taxed as either short- or long-term capital gains, depending upon how long you held the shares.

You will receive a Form 3921 from your employer that provides details of exercising the options. This information is used to complete Schedule D on your federal tax returns.

Exercising stock options may also trigger an adjustment for alternative minimum tax (AMT). Consult with your tax advisor to understand if this situation applies to you.

The $100,000 Rule rule limits how much employees can claim as incentive stock options (ISOs) in one year. ISOs receive favorable tax treatment, so the IRS places limits to prevent abuse of this tax benefit.

Any amount above $100,000 is treated as non-qualified stock options (NSOs) by the IRS. NSOs are taxed both when an employee exercises the stock option and when they sell the stock received.

Bottom Line

Stock options can be a lucrative form of compensation for employees. The potential for high payouts can “handcuff” an employee to the company and prevent them from leaving to a competitor. When stock options become vested, employees have four choices on how to proceed. After an option is exercised, taxes are owed on the difference between the current market price and the price they were granted at.

Tips on Investing

Working with a financial advisor can help you as you consider what to do with your options. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
After you’ve exercised your options, the shares are yours to hold or sell. Our capital gains calculator will help you determine how much you may owe in taxes when you sell your shares.