Non-qualified stock options NSOs are commonly issued to allow employees to participate in the upside potential of a company. Non-qualified stock options are issued at a grant price. When the price appreciates, the stock option has value. However, employers may not allow you to tap this value for years via a vesting schedule. Who would walk away from potential substantial value i. Eventually, after the stock options have vested, an employee will want to take action on these options.

Upon taking action, the employee will opt for either a cash or cashless exercise. Below, we take a look at 3 broad options for exercising non-qualified stock options, as well as the final value. When stock options are granted, they are given a vest date. The vest date is a date in the future when the employee stock option holder has the right to exercise the options. Prior to this point, the employee cannot take action.

Employers protect themselves and keep employees engaged in the on-going success of the company by setting vesting schedules well into the future. With this strategy, the goal is often to capture the stock option value immediately.

The thought for someone implementing this strategy, commonly, is to treat stock options as compensation. As compensation, the employee is not interested in waiting for the stock to appreciate or extending their holding period. By treating stock options as compensation, the singular goal is to often sell and diversify as soon as possible.

Using this strategy, the employee will elect to exercise and sell the shares immediately. If the stock price appreciates later, the employee who has chosen to sell and diversify has effectively lost out on the opportunity. However, should the stock price depreciate, the employee who diversified will take solace in the fact that they may have made a prudent decision to diversify. Similar to a vesting date that is given upon the grant of NSOs, an expiration date is also provided.

An expiration date is the date at which the shares and any subsequent value disappear, assuming that no other action is taken.

What Is a Non-Qualified Stock Option (NQSO) - Types & Issuing Options

If the current market value of the stock is lower than the grant price, then the stock options will expire as worthless. If the current market price is in excess of the grant price, then the stock options have value. Should you let options expire that have value, you are effectively throwing money out the door so I would not recommend this! Often, employees will wait until or near the expiration date to make a decision because they think that not making a decision to act is the far easier decision.

At this point, this is often the default decision. In addition, delaying the exercise of your option is also a decision to delay the tax impact. Taxes may be due upon the exercise of options. Because of this tax impact, many employees will wait as long as possible to exercise options. As the expiration date nears, the pending tax hit becomes secondary to the risk of throwing money out the window! If we extend the example above, we can assume that the expiration date is several years after the vesting date.

In lieu of exercising and selling immediately or exercising upon expiration when there is no better option, a potentially better strategy exists that may be beneficial for a highly appreciating stock. The strategy may be to exercise the options at the vest date, and then hold the shares to take advantage of long-term capital gains tax rates.

After a 1-year holding period, any gain on a future stock sale will be taxed as a long-term capital gain.

However, we must note the additional risk assumed by the employee. By exercising early, the employee was electing to pay tax sooner, rather than later.

Should the stock depreciate in value after exercise, the employee will lose. They will have paid tax on a higher amount than had they simply held the stock and not exercised. No one option is best for everyone. Some employees choose to diversify immediately, while others wait until expiration. Other things to consider should be your expected receipt of future options.

Employee Stock Options Explained - Plans, Taxation, Pros & Cons

For example, if you expect to receive options annually, you may be more inclined to sell your shares immediately and diversify. Because you may be able to participate in the upside of the company through future options, as opposed to the ones you can exercise now.

Most importantly, as the value of your stock options becomes a substantial portion of your net worth, it requires an honest discussion and evaluation of your goals to decide which exercise strategy is best for you.

Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts. None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation.

The above figures and examples are hypothetical and are for illustrative purposes only and do not attempt to predict actual results of any particular investment. I respect your privacy. Email will not be published required. Notify me of follow-up comments by email. Notify me of new posts by email. Simone Zajac Wealth Management Group Whiteland Business Park Springdale Drive, Suite Exton, PA The views and opinions expressed herein are those of the author s noted and may or may not represent the views of Capital Analysts, Inc.

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