As we’ve discussed in previous posts, stock compensation can make up a significant amount of someone’s total pay. Potentially one of the most lucrative and flexible stock compensation plans a company can provide is stock options. This plan allows you to purchase shares of the company you work for at a preset price, regardless of what the stock is actually trading for in the market. When a stock performs well, this can allow someone to purchase shares at a significantly lower price than what it is currently valued.
There are two main flavors of stock options that we will review in this post: nonqualified stock options (NQSOs) and incentive stock options (ISOs). While these two types of options function similarly, the potential tax benefits of ISOs can make them even more lucrative than their NQSO counterpart.
Like any stock plan, there are certain considerations and best practices for managing stock options. In this post, we’ll review what stock options are, how they work, and best practices for managing your plan.
What Are Stock Options and How Do They Work?
Stock options are made up of a few parts, which are key to fully capitalizing on your plan. Stock options start with a grant. The grant specifies how many shares you are able to purchase of your company and at what price. The price that you’re able to purchase at will be higher than the price that the stock is currently valued. Therefore, the hope, and the only way these options have any value, is that the stock does well and begins to trade higher than the price of the grant.
To actually get the stock, you’ll have to decide to exercise your stock options. Prior to exercise, you don’t actually own any shares, just the “right” to purchase the shares at the specified price. What happens when you exercise your stock options will depend on your plan and what your company allows. Since you will be buying the shares themselves, you may need to have the cash available to purchase the shares outright. However, what is more common is having the option to immediately sell some shares when you exercise to cover the cost of the purchase or have some shares withheld from the exercise for the same reason.
The last piece of information that is critical for managing stock options is that the options themselves don’t last forever. Usually, the option will expire after a predetermined number of years (e.g., three years, five years). If you do not utilize the option before then, you forfeit the option and receive no value from it (assuming the stock price is above the option price to begin with).
Example: In 2023, Mary was granted the option to buy 100 shares of XYZ company at $10 a share through 2028 (five years). Currently, XYZ company is trading at $5 a share, so the options have no value because they are priced higher than the current market value of the stock. In 2025, the value of XYZ company has increased and is now trading at $20 a share. Mary decides to exercise her stock options. She needs to come up with $1,000 in order to buy the shares (100 shares * $10/share). Her plan allows her to exercise the entire stock option without paying for the shares up front, but she will have to sell the necessary number of shares to cover the purchase price. The plan sells 50 shares immediately to cover the purchase (50 shares * $20/share), leaving her with the remaining 50 shares.
As mentioned previously, there are two main flavors of stock options. NQSOs are by far the more common type. ISOs need to follow Section 422 of the IRS code, which is more burdensome for companies. Since there are extra complexities to ISOs, most companies opt to go with NQSOs if they offer stock options at all. If you’re unsure whether your plan is NQSO or ISO, you can ask your plan administrator or your HR department. The type of plan that you have may determine how you want to manage your options because there are different tax considerations, depending on the type of option.
How Are NQSOs Taxed?
While stock options can come with a huge upside, that does not mean you can get all that upside tax-free. The difference between what the market value is and the exercise price determines how much taxable income you realize. This will show as ordinary income on your W-2 and is taxed at the normal income tax rates.
Taxes are withheld when you exercise the stock, similar to the example above. Taxes can be withheld from selling or withholding shares of the exercised stock. Taxes include federal income taxes, state income taxes (if applicable), Medicare, and Social Security taxes.
Once you exercise the option and receive the shares, the tax considerations are not done yet. Once you sell the shares, you may have a capital gain or loss depending on the price they are sold for. On the day you exercise the shares, the value of the shares on that day is your new basis, not the exercise price. This ensures that you are not taxed twice as income and then again on a capital gain. How long you hold the shares from exercise determines whether the gain/loss is long-term or short-term. The day you exercise is considered the day you buy the stock, not the grant date. If you hold the stock longer than a year from exercise, it’s considered long-term; less than a year, short-term.
Example: Mike has a stock option grant that allows him to purchase 100 shares of ABC company for $25 a share. ABC company is currently trading for $40 a share. He exercises the option and purchases the 100 shares at $25/share. He is taxed on $15/share as ordinary income. Two years later, Mike decides to sell the stock when it is trading at $50/share. He will realize $10 of long-term capital gains per share on the sale.
How Are ISOs Taxed?
Unlike NQSOs, ISOs are not taxed when the option is exercised. This is because the actual type of tax depends on whether the sale of the exercised stock is a qualified or disqualified disposition. In order for a sale of an ISO to be a qualified disposition, you need to sell at least two years after the grant of the option and at least one year after exercise. If the stock is sold before both of these conditions are met, the sale is considered a disqualified disposition, and it is taxed similarly to NQSOs, with the difference between the market value and exercise price taxed as ordinary income and the difference between the sale price and market value at exercise taxed as a capital gain. However, unlike NQSOs, no tax is withheld on the difference between the market value and exercise price. You will have to pay the amount of the tax due either through estimated taxes or when you file your return.
The big benefit of trying to get a qualified disposition is that if the sale is a qualified disposition, the entire amount of the discount between the market value and the exercise price is taxed as capital gain. Capital gain tax brackets are less than income tax brackets, which is the incentive for holding the stock for that period. Depending on the amount of the discount between the market value and exercise price, in addition to any market appreciation between exercise and the time of sale, the tax savings on a qualified disposition can be substantial.
Something that can happen when dealing with incentive stock options is that you may become subject to the alternate minimum tax (AMT). The way to think of AMT is as a separate tax return that is prepared alongside your normal return. The difference is that the AMT return has different tax brackets, eliminates some deductions, and includes certain income that is not included on your normal tax return. One of those income items that is on the AMT return is the discount value between the market value of the stock and your exercise price.
You only need to pay AMT when the tax due on the AMT return is larger than on your normal return. Most of the time this is not the case, so most taxpayers only pay the tax due on the regular tax return. In the case of ISOs, depending on the amount of the discount, the additional income can cause people to be subject to AMT. The income from the difference between the market value and exercise price is only included on your AMT return if the stock is held beyond the calendar year. If ISO stock is sold the same calendar year that it is exercised, then there is no additional income on the AMT return to trigger that tax.
While AMT may sound like a terrible thing, it’s not as bad as it sounds. When you are subject to AMT, you receive a tax credit for future years for the amount of AMT paid above your regular tax return. This credit will offset the taxes due on your regular tax return in years when your regular taxes are higher than your AMT. This credit is carried forward until it is used up. Depending on the amount of the credit and your tax situation in future years, this could happen quickly or take some time. A simple way to think about AMT is that it’s sort of like prepaying your future taxes. Assuming you won’t be subject to AMT indefinitely, eventually, that AMT tax credit will be used, and you will pay the same amount of taxes overall, but you will pay the amount from your ISOs a little early.
How to Manage Stock Options
Out of all the different types of stock plans, stock options are probably the trickiest to manage because you have a lot of control over the timing of when you receive the stock.
Something you should always do, regardless of whether it is an ISO or NQSO, is to exercise the option before it expires if the exercise price is less than the market value. If you don’t exercise the option, you don’t receive the stock and lose out on any discount you could have received. Therefore, it’s important to keep an inventory of all your stock options and when they expire and make sure to exercise any that are profitable before they go away.
Similarly to restricted stock units (RSUs) and employee stock purchase plans (ESPPs), if you have an NQSO plan, it often makes the most sense to exercise the option and then sell the stock immediately. Like RSUs, you’re already taxed on the amount of the discount, and your purchase price adjusts to the value of the stock at exercise. As we’ve mentioned in previous posts, there is a risk in holding stock of a single company. That risk is amplified when it’s also the company you work for where your salary and benefits are also tied to them. So, generally speaking, if you have an NQSO plan, the best course of action is to sell the remaining stock as soon as you exercise it because of the risk of holding on to the stock, and there are no real additional tax benefits for holding on to it longer.
It gets a little more complicated when the stock comes from ISOs. Since ISOs can have significantly better tax treatment, depending on your comfort level and situation, it may make sense to try for a qualified disposition. Of course, if the single stock makes up a significant amount of your total net worth, it will still probably make sense to sell right away. The risk of holding on to one stock is too great. However, if you’re otherwise properly diversified and your company stock doesn’t make up a large percentage of your total net worth, then holding the stock for a qualified disposition may make sense. However, if you find investing in a single company too risky, regardless of the possible tax benefits, it probably makes sense to sell the stock as soon as you exercise. There is always a risk that the stock can drop in value, and possibly significantly, so deciding to sell after exercising is never the wrong answer. Even with the beneficial tax treatment, if you’re being taxed less on a small total value, what you keep after tax can still be less.
Another key consideration of stock options is the ability to control when you exercise and, thus, when you are taxed on the income. It’s important to know your tax situation because some years may be more beneficial to exercise than others (as long as you can wait, and your options won’t expire). The timing of exercising your stock and your tax situation that year can determine how much of the gains you get to keep after tax. Working with a qualified tax professional or financial advisor can help review your situation.
Like all stock plans, stock options can be an excellent form of compensation your employer provides depending on the amount of the options you receive and how the stock performs. But unlike other types of stock plans, stock options are a little trickier to manage because you get to choose when you exercise the option and when you sell the stock.
There are two main types of stock options: ISOs and NQSOs. NQSOs are more common, but if you’re lucky enough to participate in an ISO plan, the additional tax benefits can be enormous, assuming you’re comfortable holding the stock for the minimum holding periods.
Of course, like everything in personal finance, how best to manage your stock option plan is unique to you and your goals. If you need help reviewing your stock plans or with your financial plan in general, please reach out to our team.