Here’s What Employee Stock Options Are and How They Work

What Are Employee Stock Options & How Do They Work?
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If you’ve started a new job and are offered employee stock options, you might see visions of a windfall. It certainly is an enticing aspect of a job offer, but whether it can boost your net worth significantly depends. 

An employee stock option is a plan that means you have the option to buy shares of the company’s stock at a certain price for a given period of time. In doing so, it could increase how much money you bring in from your job.

“Stock options are a type of compensation or bonus that your company gives you,” says Mike Zung, a certified financial planner and principal at Java Wealth Planning, a wealth planning firm for tech employees. “It’s a way for you to participate in the potential growth of the company, and it helps incentivize you to do the work that you do. If you can help the company succeed, then these options will become more and more valuable to you.”

Read on to learn what exactly are employee stock options and how they work.

What Are Stock Options for Employees?

There are three main types of stock options:

Incentive stock options (ISO): Incentive stock options, or ISOs, are set aside for employees. With an ISO, employees can purchase shares at a discounted price. As Zung explains, there are three main components of an ISO: you are granted shares, you exercise them, and then you sell them. Exercising stock means buying them at a lower price granted to you.

Non-qualified stock options (NSO): NSOs are similar to ISOs in that you also need to be vested before you can exercise them. However, while ISOs are purely for just employees, NSOs can also be offered to investors, partners, and vendors. 

Restricted stock unit (RSU): With an RSU, you’re granted a number of shares, and a portion of those shares will be vested, either when you hit a performance milestone or when you’ve been with the company for a certain number of years.

If you’re a younger investor who is entering the workforce, “any types of these programs generally are quite advantageous,” says Faron Daugs, CEO, founder and wealth advisor at Harrison Wallace. “The RSUs are generally considered a given. At least you’ll probably get some value out of them. As long as you stay with the company for over a year, you’re going to get some value out of an RSU, whereas with the non-qualified and the incentive stock options, it really depends on the price of the stock.”

Pro Tip

During the job negotiation process, you can negotiate for greater stock options and less pay, or the other way around. 

How Much Are Your Stock Options Worth?

How much your stock options are worth hinges on how much you bought them for at the discounted rate, and how much you sold them for. If a company is growing and the stocks are rising in value, then your stock options will be worth more than you paid for them.

“A common misconception people have about employee stock options is that they’re worthless and so you don’t really need to pay attention to them,” says Zung. “While that might be true in the near term, it is something that you definitely need to plan for and keep track of because there is a possibility that they become a very large part of your financial plan and could turn into essentially a windfall for you.”

That being said, it’s important to treat your employee stock options as a “bonus” until your shares are vested, adds Daugs. Vested means earning the asset, or earning the reward.

How much your stocks are worth also hinges on where the company is on its journey, says Zung. “If the company is newer than those stock options, there’s a very real possibility that they don’t work out, like the company folds or whatever,” says Zung. “And the stock options just don’t actually turn into anything of value.”

Zung advises to keep your employee stock options in your back pocket, and by no means hinge your financial plan on these options working out. “As the company goes along, and if it starts to have success and look like it’s going to go public, and sometimes there’ll be what are called tender offers where while they’re still private, the company will actually say, hey, we’re willing to buy some of the options off of some of the employees,” says Zung. “So whenever those kinds of things start to happen, then that’s whenever it’s being more deliberate in planning for them because they are starting to have real value instead of figuring out what to do with them and start to plan for them after that.”

How Are Stock Options Taxed?

NSOs flow through to your W2 as ordinary income tax, explains Daugs. So that share’s increase is going to be considered taxable income, almost like it was earned income. “It’s subject to income tax, Medicare tax, and Social Security tax,” says Daugs. 

The increase in value of ISOs is also taxed as ordinary income, explains Zung. And if you hold onto your shares for a period of time before selling them and earn a profit, that profit will be taxed as capital gains. If you wait at least a year at the time you exercise before you sell it, and wait at least two years from the time the shares were granted to you, you’ll be taxed as long-term capital gains rather than short-term capital gains. That can be the difference between a 32% tax rate and a 15% tax rate. 

For example, if those shares went up in price from $10 at the strike price (aka the time they were granted to you) to $25 at the time you sold them, then your earnings would be taxed as long-term capital gains. If you bought them for $10,000 and sold them for $25,000, $15,000 would be taxed as long-term capital gains.

When granted a job offer and you’re in a negotiation stage, you probably want to strike a balance as taking a bit more risk with your compensation to where if the stock options don’t pan out, then you’re still fine salary-wise, says Zung. And how much risk you can comfortably take depends on your own situation. For instance, if your significant other makes a really good salary then you might be able to afford to be a bit more aggressive with your risk and go heavier with your stock options. 

Experts agree that the key to wealth building is diversification, meaning having your money in hundreds of different companies and sectors instead of just one. Be sure your investment portfolio doesn’t hinge on just one company. Index funds are good options for investors because it invests your money in hundreds of different companies, which protects you from any downfall in the market. You can create a complete, well-diversified portfolio with just a few index funds.