Stock options come in two different forms: non-qualified (NQSO) and qualified (incentive stock options – ISO). This page explains the key basic concepts of NQSOs. A nonqualified stock option (NQSO) gives you the right to purchase a company’s stock for a predetermined price. Stock options can get complex. This page won’t go every detail or strategy surrounding options. This is just for the basics. Let’s run through a fictional scenario to highlight the key areas to understand:
Jane is awarded 100 NQSOs on Jan 1, 2021 with an exercise price of $10. Jane has been given the OPTION to purchase her company’s 100 awarded shares at $10 per share. Put simply, Jane has the OPTION to spend $1,000 ($10 x 100) to acquire 100 shares of her company’s stock. If the company’s current fair market value (FMV) of the stock is trading at $50, Jane would realize a $40 per share gross profit ($50 FMV – $10 exercise price per share). This is how a NQSO works in its most basic form. Here are the details Jane will need to work through:
Grant: Jan 1, 2021 is Jane’s grant date. This is the date she was awarded her options. Upon grant, your company will have you sign a grant agreement specifying all the details of the options awarded to you. At this point, it would be wise to read carefully through the agreement and to save a copy for your own records. This is NOT a taxable event.
Strike or Exercise Price: This is the predetermined price that Jane can purchase her company’s stock. A strike price that is above the FMV of the underlying stock is considered ‘under water’. Jane’s strike price is $10 per share.
Vesting: Most companies do not allow you to exercise your options immediately upon award. Companies will attach a vesting schedule to the awards to retain talent over periods of time. Your options are essentially restricted from exercising until the option vests. For example, Jane’s options will vest accordingly:
-25% of the awards on the Jan 1, 2022
-75% over the remaining 15 calendar months
This means Jane will only be allowed to exercise 25 awards (25% of 100) on January 1, 2022. 5 options will vest on Feb 1, 2022, 5 more on March 1, 2022, etc. This will continue until all the options vest or the options expire.
Expiration: Unfortunately, your options can lapse and become worthless under several circumstances. Companies set a time limit from the grant date to exercise the option. This time limit is typically 10 years from the grant date. If you quit your job, die, or become disabled, that time limit can be much shorter! Companies can also throw in other clauses if you go to work for a direct competitor. It’s key to know when your options expire upon certain life events. It’s common for individuals to think their 10-year time limit carries over when switching jobs. The expiration date typically gets changed to 60 or 90 days from the day you leave. Much shorter than 10 years from grant!
Exercise: Exercising is the action of purchasing your options. Jane’s ready to exercise her 25 shares that vested on Jan 1, 2022. Jane will need to pay $250 ($10 strike price x 25 vested shares) to exercise her options.
Bargain Element: The bargain element is the difference between the strike price of an option and the underlying stock’s FMV. This is an ESPECIALLY important concept to understand as it pertains to taxes.
Taxes: An individual who exercises NQSOs will be subject to federal, state and local (depending on residence), and FICA taxes on the bargain element. Capital gains tax will potentially be due when you sell the stock in the open market.
Withholding and Exercise Choices: Jane will be required to withhold federal and FICA taxes (and possibly state and local taxes depending on your location).
For example, let’s say Jane exercises her 25 vested options when the value of her company’s stock is trading at $50. Jane would owe federal, FICA, and state and local taxes on the bargin element, which totals $1,000 in this case (($50 FMV – $10 strike price) x 25 vested options). This $1,000 is ordinary income that would be posted to Jane’s W2.
FICA taxes consist of Social Security and Medicare. Social Security is taxed at 6.2% against all ordinary income (NQSO bargain element in this case) up to $142,800 for 2021. Medicare tax has no cap and is taxed at 1.45% against all ordinary income. There is also a 0.9% additional Medicare tax for high income earners. Be aware that you might have already maxed out your Social Security depending on when you exercise your NQSOs and how much ordinary income you had throughout the year.
Federal income taxes also require withholding at supplemental rates. The supplemental rate is 22% but increases to 37% if your supplemental income is above $1 million for the year.
Back to our example, let’s say Jane is required to withhold $250 for taxes of her total vested amount of $1,000. This means Jane has to pay $250 to exercise her shares and an additional $250 to cover the tax withholding required by her company. A total of $500 Jane is responsible for. Jane has a few choices to account for the withholding:
- One option is to pay in cash. Jane can send her company a personal check to cover the option price and the required withholding.
- Another option is to ‘sell to cover’. This popular approach allows you to sell some of your shares that just vested and use the proceeds to pay for the withholding. In the case of Jane, she would sell 5 ($250 withholding / $50 fair value per share ) of her 25 total vested shares, leaving her with a net of 20 shares.
- You also have the option of completely liquidating the entire vested amount right at exercise. The net amount after the exercise cost and withholding would be sent to you.
Please note that not every company allows all payment options for withholding. Some companies will only allow ‘sell to cover’ to pay for withholding. If vesting happens during a blackout period of which you’re not allowed to sell, you could be left in a tough spot by holding onto a large amount of company stock. Trying to manage a large, concentrated position of company shares is another discussion all together. It’s critical that you contact your company at grant/award to inquire about withholding options. Some companies will send you a form a few weeks or a month before vesting. Other companies will want to know right after grant/award.
Withholding Enough? It’s important to remember your withholding might not actually reflect the tax amount due when you’re ready to file. The supplemental withholding rate is 22%. In 2021, the 22% marginal federal income tax rate for single filers ends at $86,375. For married filers, the 22% marginal bracket ends at $172,750. If you’re in a high-income area such as the San Francisco bay area or New York, you could easily be in a much higher marginal tax bracket.
The IRS has a ‘pay-as-you-go’ system. If you aren’t withholding enough in tax at the end of the year to satisfy your safe harbor, you’ll be subject to penalties and interest. Tax planning to ensure you’re not under withholding is crucial and could prevent a larger than expected tax bill come next April 15th.
How do you prepare and ensure you’re withholding enough? You have a few options:
- Adjust your W4 to withhold extra federal taxes. The IRS allows you to withhold additional amounts on the recently revised W4. You can increase your withholding amount to account for additional tax owed beyond the supplemental rate. This on done on line 4c of the revised 2021 W4.
- Make estimated tax payments: You are eligible to make quarterly tax payments to the IRS to keep up with your tax liability throughout the year. IRS form 1040-ES provides details.
- Ensure you’re meeting your safe harbor: The IRS has a safe harbor amount you need to withhold throughout the year. The amount required will depend on a few factors, but generally it is 90% of the current year or 100% of last years, whichever is smaller.
Sale: After Jane exercises her options, she now has the option to sell her stock. For example, if Jane sells her stock for $60, she will be subject to $10 of capital gain ($60 FMV at sell – $50 basis in the stock). If Jane held the stock for more than one year after teh exercise date, she will be subject to LONG term capital gains. If she only held the stock for one year or less, she will be subject to SHORT term capital gains. Long Term capital gains are taxed at a maximum rate of 20%. Short term capital gains rates are the same as ordinary income rates.
I hope my example made this concept simple and easy to understand. The biggest decisions you need to make with NQSOs are: 1) when to exercise and 2) when to sell. Unfortunately, there’s no one right answer as everyone’s goals and situations varies. Knowing the basics will at least give you the idea of what happens during the exercise and sell events.