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What Is A Stock Option And How Does It Work? Thumbnail

What Is A Stock Option And How Does It Work?

Investment Planning

You might not be an executive, but you can still be awarded stock options. What does this mean to you? Well first, free money! But, seriously let’s talk about what type of stock option you received.

An incentive stock option (ISO) is a company benefit that gives you the right to buy shares of stock at a discounted price with a tax break on the profit. ISOs are taxed at the usually much lower capital gains tax rate.

On the other hand, non-qualified stock options known as NSOs (the more common type) are not as advantageous tax-wise as incentive stock options. That’s because they are taxed at your higher ordinary income tax rate.

 So back to the free money.  Anytime you are given something of value it is cause to celebrate! What you don’t want to do is be ignorant of what happens next.

Be aware of the key dates:

  • The grant date: The date you are given the shares and usually the date the shares are valued. This gives you the exercise price, or the price you can buy the shares of stock through your option.
  • The vesting date: The first date you can exercise your option. These dates are often either spread over 3- 4- or 5-year periods. For example, if you received 300 stock options they might vest as follows:
    1. 100 at the end of year one.
    2. 100 at the end of year two.
    3. 100 at the end of year three. 
  • The expiration date: Never forget this date. The expiration date is the final day that you can exercise your right to buy your shares at the exercise price. Should this date pass and your options go unexercised, your options simply go away — and that could mean you might lose a great opportunity.

Now, where do you get the money to pay to buy the options? 

You could use your own savings, but most people use a “sell to cover” or “cashless transaction”. Here is how it works:

  • Number of shares exercised = 1,000
  • Exercise price = $2 per share
  • Current Share price = $40
  • The cost of the exercise is equal to 1,000 x $2.00, or $2,000. In other words, you need $2,000 in cash to buy the shares. If you sell off a few of the shares to cover this $2,000 it becomes a cashless transaction.
  • You end up with shares of stock valued at $40—but you paid $2 per share.
  • You will then have to decide if you sell the remaining shares of stock and pay ordinary income taxes or if you keep the stock for one year and pay capital gains when you sell it instead.

As you can see this is where it starts to become more complicated. We recommend you talk with your tax professional or your financial advisor before you exercise the options.

We’ve touched on incentive options with this blog.  You can check out our other articles about stock options and restricted stock.

And if you’re ready to take the next step and work with a financial planner, you can learn more about how we work with clients right here.


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