Employee stock options are a popular way to recruit and incentivize employees by allowing them to participate in the upside success of a company, acting as an additional form of compensation or bonus with the potential to increase in value as a firm grows.
How do employee stock options work?
Generally, you would be issued or “granted” stock options by your company as part of an employee stock option plan. To understand how they work, let’s first look at some common terminology.
- Grant amount: This is the number of shares of stock you are allowed to buy.
- Grant price: This is the price you have to pay per share.
- Issue date: The date that the grant was issued.
- Expiration date: The date by which you have to purchase the stock, should you choose to.
- Exercise date: The date on which you actually purchase the stock.
Let’s look at a hypothetical example to see how this works.
Your employer grants you the option to buy 1,000 shares of your company stock on Jan. 1, 2022, at a price of $20 per share. You are given until Jan. 1, 2032, to decide if you wish to exercise this grant. Then, on March 1, 2027, your company’s stock reaches $40 per share, so you decide to exercise your option to purchase the stock at $20 per share.
In this case:
- Your grant amount was 1,000 shares.
- Your grant price was $20 per share.
- Your issue date was Jan. 1, 2022.
- Your expiration date was Jan. 1, 2032.
- Your exercise date was March 1, 2027.
As you can see, one of the benefits of employee stock options is that you don’t have to commit to buying shares ahead of time. As the name implies, you are given the “option” to buy the shares, which means it’s the closest you can get to a sure thing. If the share price never rises past the grant price, you don’t exercise your options, and if it does, you have a guaranteed profit.
Exercising stock options
If you decide to exercise your options before the expiration date, you generally have two different ways to go about it: You can pay cash or do a cashless exercise, which is also known as a “same-day sale.”
In the example above, if you wanted to do a cash purchase, you would simply deposit funds with your broker to cover the cost of the shares, in this case, $20,000 – the grant amount multiplied by the grant price. You would then own 1,000 shares of your company stock, which you could then either sell or hold as long as you want.
For a cashless exercise, you could exercise your options and sell just enough to cover the cost of the purchase. Again, using the example above, you would exercise the option for all 1,000 shares and sell half of them to cover the $20,000 purchase cost, leaving you with 500 fully paid-for shares.
Your brokerage firm can do these two transactions simultaneously, though it might charge a commission or processing fee.
The tax treatment of employee stock options
There are two main types of stock options that companies award to their employees:
- Incentive stock options
- Nonqualified stock options
The main difference between the two is how profits are taxed.
When you exercise NSOs, the difference between the grant price and the current price that the shares are trading for is considered a profit, even if you don’t sell the shares. And that profit is considered ordinary income, which means your employer will generally withhold federal and state income tax as well as Social Security and Medicare.
This can lead to major problems if you don’t plan accordingly. For example, if you exercise NSOs but don’t sell the shares you receive, you will still be taxed on the “profits,” and if the shares then drop and trade below your grant price, you could end up paying taxes on money that you never actually received.
In contrast, ISOs have a more favorable tax treatment because they are not taxed when exercised. In addition, if you hold your shares for more than one year from exercise and for more than two years from the original grant date, your profits are taxed as capital gains instead of ordinary income.
Other considerations for employee stock options
With most plans, if you leave your company, you have 90 days to exercise any vested stock options at their grant price. If you don’t, they will expire along with any unvested options. You already own any stock shares purchased through the employee stock option plan, so nothing changes there.
Differences between employee stock options
Employee stock option plans are just one of the three common ways for companies to provide stock options to employees. The other two are employee stock ownership plans and employee stock purchase plans. Although the terms sound very similar, it is important to clarify the difference between these three plans.
An employee stock ownership plan, also called ESOP, is a retirement plan similar to a 401k in which the company contributes to the plan in the form of its stock. The assets are held in a trust for employees, and they accrue shares in the plan over time. As the employee/participant, you do not buy or hold the stock directly. You are typically only paid out upon either termination or retirement from the company, and you can choose to roll over the funds at that time or take the distribution (with tax implications). These are often attractive to companies due to being highly tax-advantaged and to help retain employees through long-term wealth and aligned goals.
Employee stock purchase plans are a form of equity compensation in which employees can designate a regular payroll deduction to then purchase company stock. There are several rules associated with these plans, including who can participate, how much you can purchase and if the company chooses to discount the price at the offering period. Because these are not tied specifically to a retirement account, employees can choose to hold or sell the stock as they please; however, there are different tax incentives for holding it longer.
Although these can seem advantageous, we generally recommend that you don’t have more than 5% in any one stock, especially your employer’s stock, because you do not need more than that to achieve diversification. In addition, being overconcentrated in one security can cause unnecessary volatility and risk with your retirement savings. You also have the benefit of reducing what’s called company-specific or idiosyncratic risk – the risk that any one thing goes wrong with any one company.
How much to invest in company stock?
Be careful not to invest too much in company stock as your job and your retirement savings could be at risk. Over time, the company stock could become one of the biggest assets you own – perhaps more valuable than your 401k account and even more valuable than the house you own.
That is a problem – for two important reasons:
- Concentration risk. Professional money managers – those who manage mutual funds, pension funds, endowments and institutional funds – typically place no more than 5% of assets into a single stock. If you have a significant percentage of your net worth – say, 30% or more – in the shares of a single company, you are taking a risk that financial professionals would not take.
- Unemployment risk. One reason people lose their jobs is because their employer suffers a financial setback. So, at the very time the company’s stock is falling in value – possibly even to zero when it files for bankruptcy – you could find yourself out of work.
Your ability to retire comfortably could be in jeopardy if you have invested a high percentage of your retirement account in company stock. Sudden unemployment and loss of retirement funds invested in company stock has happened to people who worked at major companies like Sears, Toys“R”Us and Enron. It was bad enough that their employees lost their jobs – but even worse, it hurt their retirement accounts at the same time. So for that reason, we strongly recommend that you diversify, that you don’t put too much money in a single stock.
Ideally, you should own thousands of stocks because the returns of the stock market tend to be concentrated in a very small fraction of the stocks in the market. If you hold only a few dozen stocks, you might miss out on those few big winners.
Watch our new video detailing the three major reasons why you shouldn’t invest too much in company stock.
Want to learn more? Listen to this Everyday Wealth™ episode, which looks at how much stock is too much stock.
The rules and specifics for every employee stock options program are company-specific, so it makes sense to get a copy of your company’s plan and study the details or hire a financial professional to review them for you. If you have an employee stock option program or another equity compensation plan at your work and you want to know more about how it can work as a part of your overall integrated wealth plan, call an Edelman Financial Engines planner today. We’re here to help.
Investing strategies, such as asset allocation, diversification, or rebalancing do not assure or guarantee better performance and cannot eliminate the risk of investment losses. There are no guarantees that a portfolio employing these or any other strategy will outperform a portfolio that does not engage in such strategies. Funds and ETFs are subject to risk, including loss of principal. All investments have inherent risks. There can be no assurance that the investment strategy proposed will obtain its goal. Past performance does not guarantee future results.
Neither Edelman Financial Engines, a division of Financial Engines Advisors L.L.C., nor its affiliates offer tax or legal advice. Interested parties are strongly encouraged to seek advice from qualified tax and/or legal experts regarding the best options for your particular circumstances.