How to Make the Most of Employee Stock Options

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Main takeaways

• Employee stock options let you buy company shares at a fixed price, potentially allowing you to profit if the stock’s market value rises.

• The two main types of stock options, NSOs and ISOs, differ in who qualifies and how they’re taxed. 

• Vesting schedules determine when you earn the right to exercise your options, often encouraging you to stay with the company for several years.

• To maximize potential gains, think carefully about when to exercise your options or sell your resulting shares.

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A competitive salary is a great way to entice new hires—but so is the ability to benefit from the company’s long-term success. In recent years, employee stock options have become a more common part of compensation packages, particularly among startups and tech companies that are trying to attract and reward their staff.

Stock options can be an invaluable tool for wealth creation, yet employees frequently miss important rules and time limits and tax regulations. The following guide will help you use stock options effectively to achieve maximum financial gain.

What are employee stock options?

Stock options give you the opportunity to buy company shares at a future date at a guaranteed price. If the share goes up in value by the time you purchase them, you’re getting a discount.

The amount you pay per share—known as the exercise price—is usually equal to the stock value at the time the company grants you the options. If the stock has increased in price by the time you’re eligible to exercise the options, you’re “in the money.” That means you can purchase shares at a price that is lower than their market value.

Understanding the main types of stock options

Employee stock options usually come in two forms: non-qualified stock options (NSOs) and incentive stock options (ISOs). In both cases, you obtain the right to purchase company shares at a predetermined price. However, the eligibility requirements and tax implications differ between the two.

Non-qualified stock options

Nonqualified stock options, or NSOs, are the more widely used of the two types. They can be granted to a range of individuals, including employees, contractors and members of the board.

When you exercise NSOs, the difference between the exercise price and the stock's current market value is treated as income for tax purposes. You might also have to pay payroll taxes on that amount as well.

Should the price continue to rise by the time you sell your shares, you’ll also owe capital gains tax on the additional profit you generate.

Incentive stock options

Unlike NSOs, incentive stock options (ISOs) are only available to employees. They also have a potential advantage: Rather than owing income taxes when you exercise the options, you don’t owe any taxes until you sell your shares.

As long as you hold onto the stock for a minimum of one year after exercising the option—and two years after the grant date—the profit you receive is taxed as the more favorable long-term capital gains rate.

There is an important catch, however. Exercising ISOs can trigger the alternative minimum tax, or AMT. So if you’re a high income-earner, you may want to consult with a tax advisor before buying up shares.

NSOs and ISOs: A Comparison

	Non-qualified stock options (NSOs)	Incentive stock options (ISOs)
Eligible individuals	Employees, contractors and board members	Only employees
Taxation when exercised	Difference between exercise price and current market value taxed at ordinary tax rate	None (unless AMT is triggered)
Taxation at stock sale	Capital gains taxed on any appreciation after options are exercised	Profits taxed at long-term capital gains rate, if held at least two years after grant date and one year after exercise date.
Subject to payroll tax withholding	Yes	No

How stock option vesting works

“Vesting” is the timetable that determines when you actually earn the right to exercise your options. By making you wait several years before you can take advantage of them, the company is giving you some strong encouragement to stick around.

Typically, you can exercise a portion of your options after one year of service—known as a one-year “cliff”—with the rest of your options vesting over the next few years. For example, you may have the right to exercise 25% of your options each year until you reach your four-year work anniversary.

Once they’re granted, some plans give you up to 10 years to exercise your options. But if you leave the company—whether you quit, retire or get laid off—you could have as little as 90 days to convert them into stock.

Getting the timing right: When to exercise your options

When you choose to exercise your stock options will often make a dramatic impact on how much value they have. So how do you get your timing right? First, pay attention to whether your options are in the money. If the current stock price is higher than your exercise price—and you believe the stock still has room to grow—exercising could be a smart move.

Taxes should also play a big role in the decision—especially when it comes to exercising NSOs, since it triggers ordinary income tax right away. If you’re thinking about exercising a large number of options or your company’s stock has seen a big jump, talk to a tax advisor first. They can help you weigh your upfront costs, potential gains and tax exposure so you don’t get blindsided down the road.

Strategies to get the most out of your stock options

If you get employee stock options as part of your compensation, it’s tempting to think of them as free money. But in order to get the biggest payoff, you need to have a solid plan in place. Here are a few guiding principles to keep in mind:

1. Don’t ignore the tax clock.

When you choose to exercise and sell your options can have significant tax consequences. If you have ISOs, for instance, you only benefit from the long-term capital gains rate if you hold onto your shares for at least a year after buying the stock—and after two years have elapsed since the grant date.

2. Keep your portfolio diversified.

As valuable as options are, it’s easy to become overexposed to your company’s stock. If too much of your wealth rides on one company’s performance, a downturn could hit your job and your investments at the same time. To mitigate your risk, be sure to build a diversified portfolio outside your employer’s stock.

3. Have an exit plan.

Options don’t last forever. Most expire a decade after they’re granted to you, and they may expire sooner if you leave your employer. Plan out when you’ll exercise your options and sell your shares based on market conditions and your specific tax situation.

The upshot

Stock options can be a valuable perk, especially if your company’s stock is a solid performer. To make the most of them, however, pay attention to the expiration date and know how your choices could impact your taxes.