Employee stock options can be a valuable source of wealth for individuals, but it is important to understand how they work and how they are taxed. Unlike restricted stock units and performance shares, stock options allow employees to exercise the options at a predetermined price, known as the strike price. If the stock price is higher than the strike price at the time of exercise, the employee can profit from the difference.
There are two main types of employee stock options: incentive stock options and nonqualified stock options. The tax treatment of these options varies, with nonqualified stock options being taxed at the investor’s ordinary income tax rate at the time of exercise, while incentive stock option gains may qualify for the lower long-term capital gains rate if certain criteria are met. It is important to understand the tax implications before exercising stock options.
Diversification is key when it comes to managing company-specific risk associated with employee stock options. Employees with significant options grants may have too much of their wealth tied up in their company’s stock. One way to mitigate this risk is to divest the shares as soon as possible while considering tax implications and the company’s valuation. It may also be beneficial to exercise a portion of the options grant at a time to spread out the tax costs and take advantage of different price points.
Seeking advice from a tax or financial advisor who is knowledgeable about employee stock options is advisable to determine the best course of action. Morningstar provides personal finance content that can help individuals understand and manage their stock options effectively. By understanding the basics of employee stock options, individuals can make informed decisions about when and how to exercise their options to maximize their financial benefits.
