By Michael Torney, CFP, J.D., LL.M.
Stock options often make up an attractive component of a senior-level executive’s pay. At most large companies, options are awarded annually as an incentive to help the company meet its long-term profit goals. With sound financial planning, these awards can significantly increase an executive’s wealth.
There are different kinds of stock options with various features, including the amount of taxes paid once the awards are exercised and sold. Two major categories include incentive stock options and non-qualified stock options. This blog explains how to make the best use of non-qualified stock options (NQSO).
What is a NQSO?
A NQSO has three components:
- The right to buy a set number of shares of your company’s common stock;
- The shares have a set price;
- The shares must be exercised within a fixed period.
For example, you may be awarded the option to buy 10,000 shares in common stock at $50 per share. You have up to 10 years to exercise the shares.
The shares also have a vesting period, which is the amount of time required to hold the shares before they can be exercised. For example, if 25 percent of the shares vest each year, it will take four years until you are entitled to all 10,000 shares.
Strategies to Exercise Non-qualified Stock Options
With proper planning, an executive can earn a significant profit. Once the stock’s price rises significantly higher than the exercise price, it may be worth exercising your options. At this stage, you have three options:
- Exercise and Hold. You pay cash to your company, receive the full number of shares and hold onto them.
- Exercise and Sell. Immediately selling your shares after exercising your options. You will receive the net proceeds after paying the exercise costs. Your company will also withhold money for federal, state and other taxes.
- Sell to Cover. Exercising your options, but selling enough shares to cover the option costs and taxes.
Here’s an example showing the differences:
The 10,000 shares granted at $50 per share are worth $500,000. Let’s assume the stock price increases five percent annually during each of the next four years.
After Year 4, when all of the stock has vested, it will be worth $60.77 per share – a total of $607,700. At this point, the profit before taxes is $107,700.
However, you don’t have to cash in yet. You have 10 years until required to exercise the options. If the stock price continues to climb and reaches $75 per share after year 8, the pre-tax profit is now $250,000 – more than double the amount after Year 4. A person could recognize much higher profits by either exercising & holding the stock or continuing to hold (without exercise) their options until Year 8.
Of course, the stock price could also decline at various points during this 10-year period. While no one can accurately predict the timing of a stock’s rise and fall, a corporate executive knows the company’s direction and profit potential. Working together with your financial advisor, you can determine how much money is needed to meet key goals before deciding when to exercise and sell some or all of the shares.
Taxes
When it comes to the amount of taxes to be paid on your gains, timing is important.
The difference between the fair market value of the stock and the cost of the option will be included in compensation income on your W-2 and taxed as ordinary income when you exercise. The fair market value of the stock is then your cost basis for determining your capital gain or loss when the shares are sold.
If the stock option shares are sold less than one year after exercising them, any additional gain or loss from the fair market value cost basis at exercise is short-term capital gain. However, if the stock option shares are sold more than one year after holding them, any additional gain or loss since exercise is taxed as a long-term capital gain.
Long-term capital gain rates are often lower than ordinary income rates for highly compensated executives. The difference is significant. That’s because the maximum federal tax rate in 2023 on ordinary income is 37 percent compared to 20 percent for long-term capital gains (plus 3.8 percent for net investment income tax, if applicable).
Using our previous example, an executive who exercises their options after Year 4 and sells their shares before Year 5 at $60.77 per share has a profit of $107,700 before taxes. The executive will pay 37 percent in federal income tax on the $107,700 pre-tax profit; plus any state taxes, Medicare and Social Security taxes.
However, if they exercise after Year 4, but wait until Year 8 to sell, their $142,300 gain since exercise ($250,000 less the $107,700 taxed at exercise) will be taxed at no more than 20 percent – the capital gains maximum rate (plus 3.8% tax, if applicable).
For some types of non-qualified stock options – those with an early exercise feature – an executive may be able to pair the option with an 83(b) election. This election may save taxes for the executive and is covered in another blog post. Check your employer’s plan document to see if 83(b) elections are permitted on your non-qualified stock options.
Every executive has different financial needs and plans. If you have recently received or currently hold non-qualified stock options and would like to discuss how to maximize the value of these awards, contact our team at DuffTorneyteam@monetagroup.com. We work with many senior-level executives and offer a free consultation on how a comprehensive financial plan can help you build financial independence.
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