Nonqualified stock options (NQSOs or NSOs) sometimes dwell in the shadow of their attractive and esteemed “sibling,” incentive stock options (ISOs). That’s because ISOs are often touted as the golden child, getting all of the attention and praise, while NQSOs take a backseat. If you are granted NQSOs, do not despair! NQSOs are still a great compensatory tool. One of their biggest perks is that their tax implications are much more straightforward than ISOs. Taxes have enough complications, right? We could all use a little more simplicity and predictability in our lives.
How Do NQSOs Work?
NQSOs are a right to buy a set amount of company stock at a specified price for a predetermined period of time (grant term). There is no legal limit to an NQSO grant term, but in general, they are not longer than 10 years. NQSOs usually become available to exercise gradually through a process called vesting. When you exercise NQSOs, the difference between the price you pay (exercise or strike price) and the price of the stock on the exercise date is taxable wages, subject to income tax withholding and payroll taxes.
Example: Joe was granted 4,000 shares of stock with an exercise price of $10/share. One year later, 1,000 shares vest, and he immediately exercises all shares when they are worth $20/share. His taxable wages are $10,000 ([$20 – $10] ✖ 1,000 shares).
Exercise Methods
NQSOs can be exercised similar to ISOs. The method of exercising depends on your financial goals and personal preference.
- Pay cash to exercise, then retain all shares.
- Exercise and sell some shares to cover the cost of exercising, then retain the remaining shares.
- Exercise, then immediately sell all shares.
Unlike ISOs, which provide preferential treatment if certain holding periods are met, there typically is no substantial benefit to hold onto NQSOs after exercise. Why? You already incurred taxes based on the value of the stock at exercise. For this reason, it is not uncommon to exercise then immediately sell all exercised shares. Offloading shares after exercise also reduces your concentration in your company’s stock.
It is worth noting that this is a similar strategy utilized for RSUs (restricted stock units) as well. You incur taxes based on the value of the RSU at vesting. The advantage of NQSOs is that you have control over income recognition and subsequent tax liability based on when you elect to exercise the options.
NQSO Exercise Strategies
Strategies around NQSOs vary and have a lot to do with your financial, tax and personal preferences.
Financial Considerations
Under the time value concept, you generally benefit the most by deferring your option exercises for as long as possible until you get close to the end of your grant term. This allows the stock to appreciate over time in most circumstances.
Example: From the above example, Joe decides to exercise 1,000 options in year 8 of his grant, when the stock is now worth $100/share. His taxable wages are $90,000 ([$100 – $10] ✖ 1,000 shares). Because he waited, Joe gained an additional $80,000 of income. Furthermore, Joe was able to utilize his money for other more lucrative endeavors during years 1 – 7 simply because he opted not to exercise year 1.
Tax Considerations
If optimizing your taxes is your primary objective, then you should plan to exercise your options soon after they vest. Generally at this point, your exercise will have a smaller spread, and you will recognize less wage income subject to ordinary tax rates. After holding the shares for a year (or more), you can then sell the shares and pay tax on the gain at preferential (long-term) rates.
Example: If Joe exercises the shares at $20/share, holds them for a year, then sells them at $100/share in the highest marginal bracket, he could save close to $10,000 in taxes. This is compared to exercising the options near the end of the grant term where the spread would be much higher and the entire amount would be subject to higher, ordinary rates.
Personal Considerations
The strategy that works best for you may lie somewhere between the financial and tax considerations detailed above. You may decide to exercise your options at a specific time for other reasons, such as:
- Having a large purchase for which you need cash.
- Wanting to diversify your portfolio.
- Employment with your company is ending or has ended.
- Company stock value is going down, and the market is volatile.
You can work in tandem with a financial advisor and a tax professional who can help you calculate the best exercise strategy for your situation and goals.
Other NQSO Tips
Year-End Planning
As you near the end of the year, be mindful of your current marginal tax bracket and how close you are to the next marginal bracket. This is something your tax professional can help you determine. If you are firmly within a marginal tax bracket, it may make sense to exercise additional NQSOs, especially if you are looking to diversify.
While working with your tax professional, you can also explore deferring other types of income, giving you more room to exercise additional NQSOs. For example, If you have a large year-end bonus, see if your employer can pay it out in January. If you plan to sell stocks or other assets at a large gain, contemplate selling these in the following tax year. You may also want to hold off on a taxable Roth conversion until the next tax year. These are just a few examples.
You can also accelerate deductions to make room for additional NQSO exercises. Make sure you are maximizing all of your tax-advantaged accounts such as retirement accounts and HSAs (health savings accounts). If you itemize, you can bunch charitable deductions, i.e. donating two years’ worth of donations in one tax year (if your budget allows). You can also consider paying January’s mortgage payment in December.
Consult with your tax professional for other ideas to defer income and/or accelerate your deductions.
Planning Around Other Stock Options
It is not uncommon to have other types of stock options along with NQSOs. If you have RSU grants, be aware of any grants that may vest in the current year. This could push you into the next marginal tax bracket if you are also exercising NQSOs. If you have an RSU grant that won’t start vesting until the next tax year, it may make sense to exercise more NQSOs in the current year.
If you have ISOs, exercising NQSOs may actually help you exercise more ISOs without negatively impacting AMT (alternative minimum tax). Additional NQSO income will widen the gap between your regular tax and tentative minimum tax. This means you can exercise more ISOs without increasing your AMT. In this case, it would be best to work directly with your tax professional to project specific scenarios.
Connect With a Stock Option Expert
In spite of their simplicity, there are a number of ways you can get creative with NQSOs. Get with a trusted, competent tax professional and financial planner to see what your options are! (Yes, pun intended.)
As a Certified Public Accountant, John is passionate about helping families make great tax decisions!