Many employers now offer stock options in place of other popular benefits as a part of their employee incentive packages. Stock options can be confusing to new employees receiving them, and even some employers offering them. For example, some people do not realize that a employee stock option has no real value until it is exercised.

In this article, we take a look at stock options: what they are, how they are exercised, their tax implications, and more. We’ll also offer some suggestions on where to turn for financial advice regarding your stock option questions.

Keep in mind that exercising stock options can be complicated, and result in significant financial and tax consequences. It is highly recommended, therefore, that you consult with an attorney, accountant, or other experienced tax professional before exercising any stock option.

What Is a Stock Option?

Simply put, a stock option is a privilege giving its holder the right to purchase a particular stock at a price agreed upon by the assignor and the holder (called the “grant price”) within a specified time. Note that a stock option is a right, not an obligation, to purchase the stock, meaning that the option holder may choose to not exercise the option.

An employee stock option is a contract between an employee and her employer to purchase shares of the company’s stock, typically common stock,  at an agreed upon price within a specified time period. As mentioned above, employee stock options have become a popular benefit given to new and valuable employees as an incentive to join a company and work hard to make the company a success.

What Does It Mean to Exercise a Stock Option?

Exercising a stock option means purchasing the shares of stock per the stock option agreement. The benefit of the option to the option holder comes when the grant price is lower than the market value of the stock at the time the option is exercised. Here’s an example:

You receive a stock option as part of your compensation package as a new employee at your company. The grant (strike) price of the option is $50 per share. Your option vests (see below). The price per share for the company stock is currently $100. You decide to exercise your option. You will purchase your shares at the grant price ($50 per share). As the owner of the shares, you now have the choice of selling them or holding them. If you decide to sell at the current per share price, you will enjoy an immediate profit of $50 per share ($100 sell price minus the $50 purchase price), less taxes, fees and any other applicable expenses.

What is Vesting?

Vesting” refers to the date upon which the stock option becomes exercisable. In other words, the option holder must wait until the option “vests” before he can purchase the stock under the option agreement. A vesting date is a common feature of stock options granted as part of an employee compensation package. The purpose of the vesting date is to ensure the employee’s commitment to his job position and to making the company a success.

What is the Option Expiration Date?

All stock options come with an expiration date, that is, the last date by which the option holder must exercise her option or lose it.

4 Reasons to Exercise an Employee Stock Option Before the Expiration Date

Many people believe that it is wise to wait until just before the expiration date to exercise their stock options and purchase the option shares. And they may be right, under most circumstances. There are times, however, when exercising your options early is a good idea. Here are four reasons to consider exercising your options before the expiration date:

  1. You have good reason to believe that the company’s prospects have turned negative and you want to exercise your options and sell your shares before the stock price declines.

  2. You currently own, or hold options on, too many shares of company stock than is healthy for your overall investment portfolio.

  3. You believe the stock is a good investment for the long term and you want to buy as many shares as you can afford.

  4. Your financial gain from exercising your options all at once would push you into a higher tax bracket, so you are spreading out your stock purchases under the option agreement.

Remember that there are tax implications to exercising your stock options. More on tax considerations below.

3 Strategies To Consider When You Exercise Your Stock Options

There are three main strategies you can take when you exercise your stock options:

1. Cash for stock: Exercise-and-Hold

You purchase your option shares with cash and hold onto them. This gives you the maximum investment in company stock, providing you with potential for gains from increases in stock value and payment of dividends (if any). You may need to deposit cash into your brokerage account or borrow on margin to pay for your shares. You will also likely pay brokerage commissions, fees and taxes.

2. Cashless: Exercise-and-Sell

You purchase your option shares and then and immediately sell them. In many cases, your brokerage will allow this transaction without using your own cash, with the proceeds from the stock sale covering the purchase price, as well as the commissions, fees and taxes associated with the transaction. This choice provides you with cash in your pocket to put into other investments or use as you otherwise see fit.

3. Cashless: Exercise-and-Sell-to-Cover

You exercise the option and then immediately sell just enough shares to cover the purchase price, commissions, fees and taxes. Your resulting proceeds will remain in the form of company stock.

Stock Swaps: A stock swap is another form of cashless stock option exercise. With a stock swap, you exchange company shares that you already own to pay for the shares obtained through the exercise of your stock option. The main benefit to this choice is avoidance of taxes. Keep in mind, however, that you must hold the shares used in the exchange for a stated period of time (typically one or two years) in order to avoid the transaction being treated as a sale and incurring tax costs.

Tax Considerations in Exercising Stock Options

Tax implications will play a key in role in your decisions on when and how to exercise your stock options. Remember, poor choices can have a devastating effect on your financial well being. Always consider consulting with a tax expert before exercising any stock option.

Types of Stock Options

The IRS recognizes two types of stock options: statutory and non-statutory. Options granted through an employee stock purchase plan or incentive stock option (ISO) plan are considered statutory stock options. Options not granted through employee stock purchase plans or ISO’s are considered non-statutory stock options.

Tax Considerations for Incentive Stock Options

ISO’s are the most common type of company-granted stock option. There are three main forms of taxes that must be considered when exercising an ISO: the alternative minimum tax (AMT), your current income tax, and long-term capital gains tax.

When you exercise your options and purchase your shares at a fair market value higher than the grant price, but do not immediately sell your shares, you will likely be required to pay a federal AMT, and possibly a state AMT. The likely federal AMT tax rate will be 28% times the amount that your options have appreciated based on current market price (if your company is public), or the most recent 409A appraisal (if your company is privately-held.)

In regard to long-term capital gains taxes, consider that you will pay a more favorable long-term capital gains tax rate if you exercise your options, hold the shares for more than a year, and then sell your shares more than two years after the option grant date.

Here’s an example of how the tax costs can play out with the exercising of stock options:

  • You own 10,000 options (one share per option) to purchase common stock in your employer’s company at $1 per share.

  • The most recent 409A appraisal values the company’s common stock at $5 per share.

  • You exercise 5,000 options and purchase 5,000 shares.

In this scenario you will owe an AMT of $5,600 (5,000 shares x 28% federal AMT tax rate x ($5 - $1))

  • You then hold these shares for at least one year before selling them and pay taxes at the combined federal and state marginal long-term capital gains tax rate of 24.7% (assuming you earn $255,000 as a couple in California).

  • You sell your 5,000 shares for $10 per share.

The AMT will be credited against the taxes you owe when you sell your exercised stock earlier. In this case your combined long-term capital gains tax will be $5,515 ((5,000 shares x 24.7% tax rate x ($10 sold share price - $1 original stock strike price)) - $5,600 previously paid AMT).

Your total cash flow gain from this transaction is $38,885 (($10 sold share price X 5,000 shares) - $5,515 combined long-term capital gains tax - $5,600 federal AMT tax).

Alternatively, if you believe that your company's stock will appreciate rapidly, it may be worth exercising your stock options early and paying the higher tax rates. The result may be to accumulate a great deal of wealth from owning a larger piece of a profitable company. There are many examples of employees at startups, like Instagram, who became millionaires overnight from their stock options alone. As CNN Money reported, “Turning paper gains in options into real cash - despite exercising 'early' according to conventional wisdom - seems to have been extraordinarily prudent in retrospect.”

Where to Find Great Advice on Exercising Stock Options

Financial decisions can be extremely complicated, even for the most experienced investor. Make sure that you understand all of the legal and tax implications involved before before exercising your stock options. You can begin the process by discussing your situation directly with the legal professionals on UpCounsel's marketplace. UpCounsel gives you access to some of the nation's best lawyers from top law schools like Yale and Harvard. Get all the facts you need first, so you'll be in a position to make the best decisions about your financial future.