Is your company offering Non-Qualified Stock Options (NQSOs) and you find them confusing? Pure’s Financial Advisor, Annie Chen, CFP®, AIF® guides you through the basics, definitions, and tax implications of NQSOs, helping you better understand and leverage this valuable employee stock benefit.
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Transcript
Stock options are when a company grants the employee the right to purchase shares of the company’s stock at a pre-determined price. There are two primary types of stock options and today, we will be focusing on the non-qualified stock options. The reason why it’s called non-qualified is because of the tax treatment of these options, which we will discuss in a little more detail later.
There are a few key terms to remember when it comes to stock options:
The first is the grant date, which is the date when the stock options are awarded or granted to the employee. This is when the stock option starts vesting.
A vesting schedule is the timeline that determines when the stock options become eligible for purchase. Vesting schedules can be based on factors such as how long an employee has been with the company, if the employee achieves certain milestones or after a certain period of time.
The second term to remember is the strike price or sometimes called exercise price, which is the pre-determined price that the employee can purchase the company’s stock.
The third term is expiration date, which is the last date that the employee can exercise the stock option. After this date, the stock option becomes worthless.
And the last term is the exercise date, which is the date that the employee decides to exercise the stock options and purchase the company shares at the strike price.
Now, let’s go through an example together:
Let’s say you work for company ABC and your employer granted you stock options on May 5, 2023, which is the grant date. This stock option gives you the right to purchase 100 shares of ABC stock at the strike price of $50 per share. The expiration date for this option is 1 year from the grant date, which would be May 5, 2024.
On May 4, 2024, the day before the stock options expire, let’s say the stock price of ABC is now $70 per share. Since the stock price is higher than your strike price of $50, you exercise your stock options and purchase 100 shares of ABC stock at $50 each. This makes May 4, 2024, your exercise date and now you own 100 shares of ABC stock that you purchased for $5,000 total. If you decide to immediately sell the stocks, which are now worth $70 a share, the current value of all your shares is $7,000 and your gain would be $2,000. It’s important to note that you are not obligated to sell the stock immediately if you don’t want to. But holding onto the stock means you will experience fluctuations in the stock price, which can affect your gain positively or negatively.
Now let’s pretend that on May 4, 2024, ABC stock had actually dropped to $40 per share, which is lower than your strike price of $50 per share. In this situation, it would not make sense to exercise your stock options and they would become worthless. This is why they’re called stock options. You have the freedom to choose whether or not you would like to purchase your company stock for that pre-determined price. But it is not required.
Now that we understand how non-qualified stock options are taxed. There are no tax consequences when the stock options are granted or vested. But when a non-qualified stock option is exercised or purchased at the pre-determined price, the difference between the current value of the stock and the exercise price is considered taxable income and taxed at ordinary income tax rates.
So going back to our example, there was no tax impact on the 100 shares of ABC stock was granted but if you chose to exercise this stock option when the current value was at $70 per share, the gain of $2,000 would be considered taxable income.
Now let’s say you hold onto ABC stock and sell it when it reaches $100 per share, the gain of $3,000 would be taxed at long-term capital gain rates if you held the stock for over a year or short-term capital rates if you held the stock for less than a year.
This is the same way gains are taxed in a non-qualified account, which is why these options are called non-qualified stock options.
If your company offers non-qualified stock options, you now know the basics of how they work and how they are taxed. If you need additional guidance, take advantage of Pure’s free financial assessment and get your questions answered.
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• Investment Advisory and Financial Planning Services are offered through Pure Financial Advisors, LLC, a Registered Investment Advisor.
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CFP® – The CERTIFIED FINANCIAL PLANNER™ certification is by the Certified Financial Planner Board of Standards, Inc. To attain the right to use the CFP® designation, an individual must satisfactorily fulfill education, experience and ethics requirements as well as pass a comprehensive exam. Thirty hours of continuing education is required every two years to maintain the designation.
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