The Basics of Employee Inventory Choices

If you have ever thought about playing the stock market, then this is the employee benefit for you. When you are offered an employee stock option, you are given the opportunity to purchase company stock at a fixed price. These special stocks are a good way to earn some extra income.

There are two different types of employee stock options: non-qualified and incentive. Once you get your hands on these options, you have an allotted amount of time to actually sell them, usually no more than ten years. There are also limitations on how many shares you can exercise over the course of your vesting period.

Non-qualified Stock Options (NSO)

You’re more likely to be offered non-qualified stock options as part of your benefits package, especially if you aren’t an executive employee. These stocks are subject to income tax equal to the difference between the discounted price and the market price of the stock at the time of purchase, in addition to social security and Medicare tax.

Incentive Stock Options (ISO)

Unlike a non-qualified stock option, incentive stock options are qualified to receive tax exemptions. That does not mean these stocks are completely tax-free. You have two options: exercise your option after your waiting period (one year from the date you obtained the shares and two years from the grant date) to have the income tax waived, or sell during the waiting period and be subject to the same income tax as you would with an NSO.  In comparison to NSOs, there are also more restrictions imposed on these stocks. You have a yearly limit of $100,000 when exercising your stocks, and you are not able to transfer your stocks to your children or anyone else unless stated in your will.

Exercising your Stock Options

You will likely have a “waiting period” before you are able to exercise your stock. Some plans may prevent you from selling them all at once; in this case, you would only be able to sell a percentage of stocks in a year over the a certain amount of years. For example, you can exercise 20% of your shares over five years.

You don’t want to exercise too early, but there are risks inherent in waiting until the end of your vesting period. If you move into a higher tax bracket, you have to pay a higher income tax on your NSOs. Holding onto stocks until the last minute will force you to sell for whatever price you can get, profitable or not.