The Three Things You Need to Know If You Have Incentive Stock Options

If you have been offered stock options by your employer, it’s tempting to see them as a ticket to riches. And you can use this award-winning stock option calculator to calculate what your options may be worth.

However, getting the options is only a start. In reality, there has been many a slip between the cup and the lip. It turns out, the way you manage the options is important if you hope to successfully cash in on them. Not all stock option holders are laughing all the way to the bank.

The devil with stock options is in the details, as many employees who were given options during the dot-com boom found out the hard way. If you are not savvy about stock options, you might find yourself caught on the wrong foot – such as owing a large tax bill on worthless stock.

So how can you stay on the right foot? Read on for the three things you need to know.

When You Can Exercise

When you can exercise your options is called “vesting.” It turns out, you don’t have access to your options until you’ve been at the company a certain time or the company has met certain performance benchmarks. A typical early-stage company options package “vests” over four years. Options typically vest monthly, except if there’s a one-year “cliff,” which means you need to wait a year to get any.

Additionally, your options expire after ten years from the date of grant. And if you are laid off before you are vested in your options or your company is acquired by another company, you may lose your unvested options. All of these details should be in your stock option agreement.

How You Can Exercise

Ready to exercise? Your first option is to exercise the options with cash and get the stock in exchange. This strategy gets you the best tax treatment, but means you a) need to find the cash to do it and b) risk losing that money if the company goes kaput.

Your second option is referred to as a “cashless exercise.” That means, you can decide to exercise your options and sell just enough of the stock that you receive to cover the costs you incurred to exercise. In this case, you don’t need to pony up cash but you still risk a loss if your company disappears.

Your third option is to wait to exercise and sell all of the shares you receive immediately. This way, you won’t have any ongoing exposure to the stock price volatility. Also, you won’t have to come up with the upfront cash you need to exercise the options. But your tax implications are the worst.

Tax Implications

The tax rules that apply to stock options are complex, so here are some rules of thumb.

If you can afford to wait to hit certain milestones, your tax treatment will be better.You will receive the most favorable tax treatment if you wait for two years from grant date and one year from date of exercise to sell your shares. Any profit you generate from the sale of your stock will be taxed as long-term capital gains.

Exercising or selling before milestones can mean ordinary income treatment (higher taxes). If you sell in the same calendar year of exercising, within a year of exercising or after more than a year, but less than two years from grant date, you’ll have more complicated and higher taxes.

Because everyone’s options package and financial situation is unique, this is a case where it can be helpful to speak to a professional. A financial advisor or tax planner can help you walk through the mechanics of your stock options. Schedule an appointment with a Personal Capital advisor to find out how to make the most of your options.

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