Maximize Your Stock Options to Build Wealth

True Root Financial is a financial advisor and financial planner based in San Francisco, CA. We serve clients across the globe.

Stock options are a powerful tool for building wealth, particularly for tech professionals and employees in fast-growing companies. However, they can be complex, with several factors influencing how much value you ultimately receive.

If you are a tech professional interested in learning how we can help claim your financial independence by investing wisely, minimizing taxes and maximizing your equity compensation, please book a no obligation call here.

Explore a deeper understanding of stock options and wealth-building strategies in our in-depth video below:

Understanding Stock Options: Features and Key Information

What Are Stock Options?

Stock options are the right to buy the stock at a certain price called the strike price. Intrinsic value and time value. What makes them valuable is that typically, the strike price is greater than the fair market price. So the difference between the strike price and the fair market price is the intrinsic value of the option. That’s when the option is in the money. Now, options can be out of money meaning that the strike price is more than the fair market price. So, in that case the time value becomes important. Time value is the potential profit.

What You Need to Know About Your Stock Options

Several factors influence when and how to exercise your stock options:

Grant Terms: The specific terms outlined in your stock plan documents, including when you can exercise your options.
Vesting Schedule: The timeline over which your stock options become exercisable.
Types of Stock Options: Know whether you have Incentive Stock Options (ISOs) or Non-Qualified Stock Options (NQSOs), as this affects taxation.
Exit Strategy: What happens to your options if you leave your company? It’s crucial to understand this before making decisions.

Documents You’ll Need

Understanding your options requires gathering the correct documents:

Stock Plan and Grant Agreement: Outlines the rules of your stock options.
Grant Notice: Details specific terms for your stock options.
Employment Agreement: Confirms that the terms align with your original offer.

Types of Stock Options

There are two types of stock options – incentive and non qualified stock options. Incentive stock options are typically granted to early employees and non qualified stock options are granted to employees once the company matures more. It’s really important to know what type of option you have as that will determine tax implications.

Taxation of Stock Options: ISO vs. NQSO

Non-Qualified Stock Options (NQSOs)

With NQSOs, taxation occurs at two critical points: when you exercise and when you sell.

When you exercise a non qualified stock option, the difference between the fair market value of the stock and the strike price is considered income. What is the fair market value? For a public company, it’s the price of the stock, for a private company, it’s the 409A valuation, which is typically updated each year that you can get from your company. Let’s say your strike price is $1 and the fair market value of the company is $6. The difference of $5 is your profit that will be taxed as income tax.

You’ll have to report this profit as income and it’ll be taxed like your regular income. Meaning you’ll pay both federal and state income tax as well as payroll taxes. Your company will withhold the standard 22%. But it might not be enough and you might owe more taxes when you file taxes next year on April 15. So, you have to make sure that you keep enough cash aside to pay taxes.

How do you pay the taxes and the exercise of options? If you’re able to sell the shares right way you can do a cashless exercise. This just means that you’ll be able to pay for both the exercise and taxes with the sale of stock. This is generally available for public company shares and might be available for private shares depending on your company.

Sale of Stock:

Once you exercise your NQSOs, the next taxable event is when you sell the stock. When you sell the stock, the difference between the fair market value at exercise and the price you sell the shares as is considered your capital gain and you will pay capital gain taxes on it. In our previous example, where you exercised your option when the fair market value of the company was $6 . Let’s say you sold those shares for $10. Now, the difference between $10 and $6, which is $4 is your capital gains. Is it long-term or short term capital gains? That depends on how long you held the shares. If you held the shares for longer than a year, it’s long term capital gains and you’ll be taxed. Long term capital gains tax rate is anywhere from 15%-23.8% depending on your income. Plus, you will also owe capital gains tax rate of anywhere from 9.3-13.3% depending on your income.

Should we exercise the non qualified stock option now and wait for the stock price to go up so that you can take advantage of the price increase?

The answer is generally no. It’s best to exercise and sell non-qualified stock options at the same time. First, you need cash to pay for the exercise and for the tax withholding. If you don’t sell the shares right way, you will need to come up with the exercise price and tax withholding yourself. Second, it’s possible that the stock price might go up but it’s also possible that it might go down. If it goes up, great but if it goes down, you just paid high income taxes on the profit of the stock sale but were not able to realize it by selling.

In a volatile market where the stock price has gone down a lot, should I exercise the non-qual now and get the lower income tax and sell the stock later once it comes up and take the capital gains?

In theory yes, that might make sense if everything works out perfectly but in reality when you do that, you’re concentrating so much of your asset in one stock by putting additional money to pay for the exercise and taxes there, that it’s better to just exercise and sell the stock, then put the proceeds in the diversified stock portfolio. If you really believe that the company stock will recover in the future, you could use some of the proceeds to buy the stock in the market and hold it as a part of your portfolio.

Incentive Stock Options (ISOs)

ISOs have more favorable tax treatment, but only if certain conditions are met:

Hold the stock for at least 2 years from the grant date and 1 year from the exercise date. If you meet these criteria, the profit from both the exercise and sale is taxed as capital gains, which is lower than income tax. This can be a big advantage compared to non qualified stock options because capital gain taxes are generally lower than income taxes.

Now let’s illustrate this with an example:

Let’s take the same example as before where you have a stock option with a strike price of $1. You sell the stock at $6 and make a profit of $5. Now you will be taxed on this $5 but unlike a non qualified stock option, you will pay a long term capital gain tax on this profit and also unlike a non qualified stock option, you will pay tax when you finally sell the stock. In other words, nothing is withheld from exercise.

When you do sell the shares a year later, say you sell the shares at a price of $10. Your gain of $4 which is the difference between the sale price of $10 and the fair market value of the stock upon exercise of $6, you pay capital gain on that gain as well as the original profit of you have a capital gain from the you pay capital gains on the difference between the strike price. So in this case, you pay a capital gain tax of 15%-23.8% federal and California taxes on the full $9 of gains you made from the exercise and sale of the option.

However, exercising ISOs can trigger the Alternative Minimum Tax (AMT), a separate tax calculation designed to ensure that higher-income individuals pay a minimum tax. AMT can be triggered if you exercise your ISOs and hold the stock through the end of the year, so careful planning with a financial advisor is crucial to avoid unexpected tax liabilities.

Disqualifying Disposition

Now, if you don’t meet either or both of these requirements, you end up with something called a disqualifying disposition. Which means that you owe income taxes on the profit at exercise. So, in our example above, if the strike price is $1 and the fair market price of the stock at exercise is $6, you owe income tax on the $5 and then again when you sell the stock, let’s say you wait to sell the stock until it reaches $10, you again have capital gains on the $4 or difference between the fair market value at exercise and the sale price. So, in this way, you’re taxed a lot like a non qualified stock option than an incentive stock option.

Now with Isos, no taxes are withheld by the company at exercise or sale. So, you have to make sure that you have enough to pay your taxes come April 15 of next year. You might need to make estimated taxes in the year itself. So, it’s really important to speak with a financial advisor and or a CPA about this.

Exercise and Sale Strategies

NQSO Exercise and Sale Strategy

For NQSOs, it’s often best to exercise and sell simultaneously to avoid the risk of the stock price dropping. This allows you to cover the costs of exercise and taxes with the proceeds from the sale, which is known as a cashless exercise. Holding onto the stock increases your risk, particularly if the stock price declines, leaving you with a high tax bill but no profit.

ISO Exercise Strategy

With ISOs, it’s ideal to exercise when the fair market value is close to the strike price. This minimizes the AMT liability while allowing you to benefit from the stock’s appreciation. However, if the stock is private, holding for a long time can be risky, especially if the company doesn’t go public. In this case, it may make sense to exercise some options early and sell to avoid over-concentrating your wealth in company stock.

Key Factors in Stock Option Strategy

Your stock option strategy depends on several personal and company-specific factors:

Personal Financial Goals: Are you looking to use the money for immediate needs or long-term growth?
Concentration of Wealth: Are you holding too much of your wealth in one stock? Diversifying your portfolio may be safer.
Company Situation: Are you planning to leave the company soon? If so, make sure to exercise any vested options within the required timeframe.

Long-Term Planning for Stock Options

If you have a significant amount of stock options, it’s essential to develop a multi-year exercise plan. Spreading out your option exercises over time can help minimize your tax liability and reduce the risk of holding too much company stock at once.

Similarly, if it’s a private company, holding the stock for longer can be risky as the exit event might never happen. So, it might make sense to disqualify some of the options. This is again a risk management decision that a financial advisor can help you with.

Next Step For You

Maximizing your stock options requires careful planning, especially when it comes to taxation and timing. Both NQSOs and ISOs offer unique benefits and challenges, and understanding the tax implications and exercise strategies can help you make the most of these opportunities. Consulting with a financial advisor is essential for crafting a strategy that fits your personal financial goals and mitigates risk. Schedule a call with us below to get expert guidance on building wealth through smart stock option strategies.

Maximize Your Stock Options to Build Wealth