Non qualified stock options after leaving company

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Perhaps you’ve heard about the Google millionaires: 1,000 of the company’s early employees (including the company masseuse) who earned their wealth through company stock options. A terrific story, but unfortunately, not all stock options have as happy an ending. Pets and Webvan, for example, went bankrupt after high-profile Initial Public Offerings, leaving stock grants worthless.

Stock options can be a nice benefit, but the value behind the offer can vary significantly. There are simply no guarantees. So, whether you’re considering a job offer that includes a stock grant, or you hold stock as part of your current compensation, it’s crucial to understand the basics.

What types of stock plans are out there, and how do they work?

How do I know when to exercise, hold or sell?

What are the tax implications?

How should I think about stock or equity compensation relative to my total compensation and any other savings and investments I might have?

1. What are the most common types of employee stock offerings?

Two of the most common employee stock offerings are stock options and restricted stock.

Employee stock options are the most common among startup companies. The options give you the opportunity to purchase shares of your company’s stock at a specified price, typically referred to as the “strike” price. Your right to purchase – or “exercise” – stock options is subject to a vesting schedule, which defines when you can exercise the options.

Let’s take an example. Say you’re granted 300 options with a strike price of $10 each that vest equally over a three-year period. At the end of the first year, you would have the right to exercise 100 shares of stock for $10 per share. If, at that time, the company’s share price had risen to $15 per share, you have the opportunity to purchase the stock for $5 below the market price, which, if you exercise and sell concurrently, represents a $500 pre-tax profit.

At the end of the second year, 100 more shares will vest. Now, in our example, let’s say the company’s stock price has declined to $8 per share. In this scenario, you would not exercise your options, as you’d be paying $10 for something you could purchase for $8 in the open market. You may hear this referred to as options being “out of the money” or “under water.” The good news is that the loss is on paper, as you have not invested actual cash. You retain the right to exercise the shares and can keep an eye on the company’s stock price. Later, you may choose to take action if the market price goes higher than the strike price – or when it is back “in the money.”

At the end of the third year, the final 100 shares would vest, and you’d have the right to exercise those shares. Your decision to do so would depend on a number of factors, including, but not limited to, the stock’s market price. Once you’ve exercised vested options, you can either sell the shares right away or hold onto them as part of your stock portfolio.

Restricted stock grants (which may include either Awards or Units) provide employees with a right to receive shares at little or no cost. As with stock options, restricted stock grants are subject to a vesting schedule, typically tied to either passage of time or achievement of a specific goal. This means that you’ll either have to wait a certain period of time and/or meet certain goals before you earn the right to receive the shares. Keep in mind that the vesting of restricted stock grants is a taxable event. This means that taxes will have to be paid based on the value of the shares at the time they vest. Your employer decides which tax payment options are available to you – these may include paying cash, selling some of the vested shares, or having your employer withhold some of the shares.

2. What’s the difference between “incentive” and “non-qualified” stock options?

This is a fairly complex area related to the current tax code. Therefore, you should consult your tax advisor to better understand your personal situation. The difference primarily lies in how the two are taxed. Incentive stock options qualify for special tax treatment by the IRS, meaning taxes generally don’t have to be paid when these options are exercised. And resulting gain or loss may qualify as long-term capital gains or loss if held more than a year.

Non-qualified options, on the other hand, can result in ordinary taxable income when exercised. Tax is based on the difference between the exercise price and fair market value at the time of exercise. Subsequent sales may result in capital gain or loss – short or long term, depending on duration held.

3. What about taxes?

Tax treatment for each transaction will depend on the type of stock option you own and other variables related to your individual situation. Before you exercise your options and/or sell shares, you’ll want to carefully consider the consequences of the transaction. For specific advice, you should consult a tax advisor or accountant.

4. How do I know whether to hold or sell after I exercise?

When it comes to employee stock options and shares, the decision to hold or sell boils down to the basics of long term investing. Ask yourself: how much risk am I willing to take? Is my portfolio well-diversified based on my current needs and goals? How does this investment fit in with my overall financial strategy? Your decision to exercise, hold or sell some or all of your shares should consider these questions.

Many people choose what is referred to as a same-day sale or cashless exercise in which you exercise your vested options and simultaneously sell the shares. This provides immediate access to your actual proceeds (profit, less associated commissions, fees and taxes). Many firms make tools available that help plan a participant's model in advance and estimate proceeds from a particular transaction. In all cases, you should consult a tax advisor or financial planner for advice on your personal financial situation.

5. I believe in my company’s future. How much of its stock should I own?

It is great to have confidence in your employer, but you should consider your total portfolio and overall diversification strategy when thinking about any investment – including one in company stock. In general, it’s best not to have a portfolio that is overly dependent on any one investment.

6. I work for a privately-held startup. If this company never goes public or is purchased by another company before going public, what happens to the stock?

There is no single answer to this. The answer is often defined in the terms of the company’s stock plan and/or the transaction terms. If a company remains private, there may be limited opportunities to sell vested or unrestricted shares, but it will vary by the plan and the company.

For instance, a private company may allow employees to sell their vested option rights on secondary or other marketplaces. In the case of an acquisition, some buyers will accelerate the vesting schedule and pay all options holders the difference between the strike price and the acquisition share price, while other buyers might convert unvested stock to a stock plan in the acquiring company. Again, this will vary by plan and transaction.

7. I still have a lot of questions. How can I learn more?

Your manager or someone in your company’s HR department can likely provide more details about your company’s plan – and the benefits you qualify for under the plan. You should also consult your financial planner or tax advisor to ensure you understand how stock grants, vesting events, exercising and selling affect your personal tax situation.

Images courtesy of iStockphoto, DNY59, Flickr, Vicki's Pics.

Six employee stock plan mistakes to avoid.

Understanding tax implications and your plan’s rules are among the keys to success.

Stock Plans.

Financial Planning Stock Plans.

Financial Planning Stock Plans.

Financial Planning Stock Plans.

Financial Planning Stock Plans.

Financial Planning Stock Plans.

Stock options and employee stock purchase programs can be good opportunities to help build potential financial wealth. When managed properly, these benefits can help pay for future college expenses, retirement, or even a vacation home.

But many investors get tripped up, don’t pay attention to critical dates, and haphazardly manage their employee stock option grants. Ultimately, they lose out on the many benefits these stock option plans can potentially provide.

To help ensure that you maximize your stock option benefits, avoid making these six common mistakes:

Mistake #1: Allowing in-the-money stock options to expire.

A stock option grant provides an opportunity to buy a predetermined number of shares of your employer’s company stock at a pre-established price, known as the exercise or strike price. Typically, there is a vesting period ranging from one to four years, and you may have up to 10 years in which to exercise your options to buy the stock.

A stock option is considered “in the money” when it is trading above the original strike price. Say, hypothetically, you have the option to buy 1,000 shares of your employer’s stock at $25 a share. If the stock is currently trading at $50 a share, your options would be $25 a share in the money. If you exercised them and immediately sold the shares at $50, you’d enjoy a pretax profit of $25,000.

You may be tempted to delay exercise as long as possible in the hope that the company’s stock price continues to go up. Delaying will allow you to postpone any tax impact of the exchange, and could increase the gains you realize if you exercise and then sell the shares. But stock option grants are a use-it-or-lose it proposition, which means you must exercise your options before the end of the expiration period. If you don’t act in time, you forfeit your opportunity to exercise the option and buy the stock at the strike price. When this happens, you could end up leaving money on the table, with no recourse.

In some cases, in-the-money options expire worthless because employees simply forget about the deadline. In other cases, employees may plan to exercise on the last possible day, but may get distracted and therefore fail to take necessary action.

“Ask yourself how much extra value you may get by waiting until the last second to exercise your award, and determine if that’s worth the risk of letting the award expire worthless,” says Carl Stegman, senior vice president, Fidelity Stock Plan Services.

Consider these factors when choosing the right time to exercise your stock options:

What are your expectations for the stock price and the stock market in general? If you think the stock has peaked or is likely to fall in the future, consider exercising and selling. If you think it may continue to go up, you may want to exercise and hold the stock, or delay exercising your options. How much time remains until the stock option expires? If you are within 60 days of expiration, it may be time to act, to avoid the risk of letting the options expire worthless. Will you be in the same tax bracket, or a higher or lower one, when you are ready to exercise your options? Taxes have the potential to eat into your returns, so you may want to exercise and sell when you are in the lowest tax bracket possible—though this is just one factor to weigh in your decision.

Tip: Monitor your vesting schedule, keep your contact information updated, and respond to any reminders you receive from your employer or stock plan administrator.

Mistake #2: Failing to understand the tax consequences of ISOs.

There are two kinds of stock option grants: incentive stock options (ISOs) and nonqualified stock options (NSOs). When you receive an ISO grant, there’s no immediate tax effect and you do not have to pay regular income taxes when you exercise your options, although the value of the discount your employer provided and the gain may be subject to alternative minimum tax. However, when you sell shares of the stock, you’ll be required to pay capital gains taxes, assuming you sold the shares at a price higher than your strike price. You must hold your shares at least one year from the date of the exercise and two years from the grant date to qualify for the long-term capital gains rate.

If you sell ISO shares before the required holding period, this is known as a disqualifying disposition. In such a case, the difference between the fair market value of the stock at exercise (the strike price) and the grant price—or the entire amount of gain on the sale, if less—will be taxed as ordinary income, and any remaining gain is taxed as a capital gain. For most people, their ordinary income tax rate is higher than the long-term capital gains tax rate.

While taxes are important, they should not be your sole consideration. You also need to consider the risk that your company’s stock price could decline from its current level. “Be aware of your tax situation, but also understand where you are in the marketplace, because there are also risks to continuing to hold the shares,” says Stegman. “Know which shares are qualified for special tax treatment, what the holding periods are, and transact accordingly.”

Tip: Consult with a tax advisor before you exercise options or sell company stock acquired through an equity compensation plan.

Mistake #3: Not knowing stock plan rules when you leave the company.

When you leave your employer, whether it’s due to a new job, a layoff, or retirement, it’s important not to leave your stock option grants behind. Under most companies’ stock plan rules, you will have no more than 90 days to exercise any existing stock option grants. While you may receive a severance package that lasts six months or more, do not confuse the terms of that package with the expiration date on your stock option grants.

If your company is acquired by a competitor or merges with another company, your vesting could be accelerated. In some cases, you might have the opportunity to immediately exercise your options. However, be sure to check the terms of the merger or acquisition before acting. Find out if the options you own in your current company’s stock will be converted to options to acquire shares in the new company.

Tip: Contact HR for details on your stock option grants before you leave your employer, or if your company merges with another company.

Mistake #4: Concentrating too much of your wealth in company stock.

Earning compensation in the form of company stock or options to buy company stock can be highly lucrative, especially when you work for a company whose stock price has been rising for a long time. At the same time, you should consider whether you have too much of your personal wealth tied to a single stock.

Why? There are two main reasons. From an investment perspective, having your investments highly concentrated in a single stock, rather than in a diversified portfolio, exposes you to excess volatility, based on that one company. Moreover, when that company is also your employer, your financial well-being is already highly concentrated in the fortunes of that company in the form of your job, your paycheck, and your benefits, and possibly even your retirement savings.

History, too, is littered with formerly high-flying companies that later became insolvent. When Enron filed for bankruptcy in 1999, more than $1 billion in employee retirement savings evaporated into thin air. More recently, Lehman Brothers employees shared a similar fate.

Consider, too, that income from your employer pays your nondiscretionary monthly bills and your health insurance. Should your company’s fortunes take a turn for the worse, you could find yourself out of a job, with no health insurance and a depleted nest egg.

“Stock from an equity plan is usually a large component of an employee’s annual compensation, so it’s easy to become overly concentrated in your employer’s stock,” says Stegman. “But you need to take a step back, consider how these benefits fit into your long-term financial objectives, such as college savings, retirement, or a vacation home, and develop a plan to diversify accordingly.”

Tip: Consult with a financial advisor to ensure that your investments are appropriately diversified.

Mistake #5: Ignoring your company’s employee stock purchase plan.

Employee Stock Purchase Plans (ESPPs) allow you to purchase your employer’s stock, usually at a discount from the stock’s current fair market value. These discounts typically range from 5% to 15%. Many plans also offer a “look-back option,” which allows you to buy the stock based on the price on the first or last day of the offering period, whichever is lower. If your company offers a 15% discount and the stock rose 5% during the period, you could buy the stock at a 20% discount, already a healthy pretax gain.

Unfortunately, some employees fail to take advantage of their company's ESPP. If you are not participating, you may want to give your ESPP a second look.

Entry-level employees often opt out of their ESPP, notes Stegman. “But as they become more established in their careers and more financially secure, they should reconsider their ESPP. Depending on the discount your company offers, you could be passing on the opportunity to buy your company's stock at a significant discount.”

Tip: Look at your current savings strategy—including emergency fund and retirement savings—and consider putting some of your savings in an ESPP. You may be able to use future raises to fund the plan without impacting your lifestyle.

Mistake #6: Failing to update your beneficiary information.

Few people like to think about it, but it’s important to keep your beneficiary designations up to date. As with your 401(k) plan or any IRAs you own, your beneficiary designation form allows you to determine who will receive your assets when you die—outside of your will. It’s important to note, however, that if the decedent has made no beneficiary designation, under most plan rules the executor (or administrator) will, in fact, treat equity compensation as an asset of the decedent's estate.

Each time you receive an equity award, your employer will ask you to fill out a beneficiary form. Many grants range in life from three to ten years, during which time many factors can change in your life. For example, if you were single when you received an option grant, you may have named a sibling as the beneficiary. But five years later, you may be married with kids, in which case you would likely want to change your beneficiaries to your spouse and/or children. The same holds true if you were married and got divorced, or divorced and remarried. It’s important to always update your beneficiaries.

Tip: Review your beneficiaries for your equity awards—as well as your retirement accounts—on an annual basis.

Learn more.

Understand the different types of employee compensation plans. Read Viewpoints: "Make the most of company stock."

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Exercising options to buy leaving stock at below-market price triggers a tax bill. How much tax you pay when you sell the stock depends on when non sell it. The tax catch is that after you exercise the options to purchase stock but not beforeyou have taxable income equal to the difference between the stock price set by the option and the market price of company stock. In tax lingo, that's called non compensation element. The compensation element is basically the amount of discount you get when you buy the stock at the option exercise price instead of at the current market price. You calculate the compensation element by subtracting the exercise price from the market value. The market value of the after is the stock price on the day you exercise your options to buy the stock. The exercise price is the amount that you can buy the stock for according to your option company. Your company must options the compensation element as an addition to your wages on your Form W-2 in the year you exercise the options. You will owe stock tax and Social Security and Medicare taxes on the compensation element. If you are given an option agreement that allows you to purchase 1, shares of company stock, you have stock granted the option to purchase stock. How you report your stock option transactions depends non the type of transaction. Leaving, taxable Nonqualified Stock Option transactions fall into four possible categories:. Each of these four scenarios has its own tax issues as the following four tax examples show. In this situation, you exercise your option to purchase the shares but you do not sell the shares. Why is it reported on your W-2? What if for some reason the compensation element is not included in Box 1? Next, you have to report the actual sale of the stock on your Schedule D, Capital Gains and Losses, Part I. 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Employee Stock Purchase Plans. How to Report Stock Options on Your Tax Return. When to Use IRS Form for Stock Sales. What Are Deductible Investment Interest Expenses? Tax Tips for Investors. Tax Tips for Landlords. Guide to Short-term vs Long-term Capital Leaving Taxes Brokerage Qualified, etc. Estimate your company refund and avoid any surprises. Adjust your W-4 for a bigger refund or paycheck. Enter your annual expenses to estimate your tax savings. Learn who you can claim as a dependent on your tax return. Turn your charitable donations into big deductions. Leaving a personalized list of the tax documents you'll need. Find out what you're eligible to claim on your tax return. Find your tax bracket to make better financial decisions. The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional leaving. Site Map Affiliates and Partners Software and License Agreements Privacy Statements Security Security Certification of the TurboTax Online application has been performed by C-Level Security. Trademark Notices About Intuit Search Intuit Jobs Press Leaving accessing and using this page you agree to the Terms and Conditions. Skip To Main Qualified. Non-Qualified Stock Non Updated for Tax Year OVERVIEW Exercising options to buy company stock at below-market price triggers a tax bill. Compensation element The compensation element is basically the amount of discount you get when you buy the stock at the option exercise price stock of at non current market price. When do I have to pay taxes on qualified options? Usually, taxable Non Stock Option transactions fall into four non categories: You exercise your option to purchase the shares and you hold onto the shares. You exercise your option to purchase the shares, non then you sell the shares qualified same day. Company exercise the option to purchase the shares, then you sell them within a year or less after the day you purchased them. You exercise the option to purchase the shares, then you sell them more than a year after the day you purchased them. You exercise your option to purchase the company and hold onto them. You after your option to purchase the shares and then sell them the same day. The cost basis is your original cost the value of the stock, consisting of what you paid, plus the compensation element that you have to report as compensation income on your Form You exercise the option to purchase the shares and then sell them within a year or less after the day you purchased stock. Because you sold the stock, you must report the sale on options Schedule D. You exercise the option to purchase the shares, then sell them more than a year after the day you purchased them. Things to remember when granted stock options When you are granted nonqualified stock options, get a copy of the option agreement from your employer after read it carefully. Looking for more information? More in Investments and Taxes 5 Things You Should Know About Capital Gains Tax What Are Deductible Investment Leaving Expenses? Tax Tips for Investors Tax Tips for Landlords Guide to Short-term vs Long-term Capital Gains Taxes Brokerage Accounts, etc. Get more with these free tax calculators and money-finding tools. TaxCaster Calculator Estimate your tax refund and qualified any surprises. W-4 Withholding Calculator Adjust your W-4 for a bigger refund or paycheck. Self-Employed Expense Estimator Enter your annual expenses after estimate your tax savings. Documents Checklist Get a personalized list of the tax documents you'll need. Tax Bracket Calculator Find your tax bracket to make better financial decisions. 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Determining Basis in Employee Stock Options.

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Exercising Nonqualified Stock Options.

What you need to know when you exercise nonqualified stock options.

Your nonqualified stock option gives you the right to buy stock at a specified price. You exercise that right when you notify your employer of your purchase in accordance with the terms of the option agreement. The precise tax consequences of exercising a nonqualified stock option depend on the manner of exercising the option. But in general you'll report compensation income equal to the bargain element at the time of exercise.

Note: The rules described here apply if the stock is vested when you receive it. Generally, stock is vested if you have an unrestricted right to sell it, or you can quit your job without giving up any of the value of the stock. See When Stock Is Vested. If the stock isn't vested when you exercise the option, apply the rules for restricted stock described in Buying Employer Stock and Section 83b Election.

Bargain element.

The bargain element in the exercise of an option is the difference between the value of the stock on the exercise date and the amount paid for the stock.

Example: You have an option that gives you the right to buy 1,000 shares of stock for $15 per share. If you exercise the entire option at a time when the value of the stock is $40 per share, the bargain element is $25,000 ($40,000 minus $15,000).

The value of the stock should be determined as of the date of exercise. For publicly traded stock the value is usually determined as the average between the high and low reported sales for that date. For privately held companies the value must be determined by other means, perhaps by reference to recent private transactions in the company's stock or an overall appraisal of the company.

Bargain element as income.

The bargain element in the exercise of an option received for services is considered compensation income. In the example above, you would report $25,000 of income, just as if the company had paid you a cash bonus of $25,000. You're not allowed to treat this amount as capital gain.

The amount of tax you'll pay depends on your tax bracket. If the entire amount falls in the 30% bracket, for example, you'll pay $7,500 (plus any state or local income tax). If you exercise a large option, it's likely that some of the income will push up into a higher tax bracket than your usual one.

The important thing to focus on — ahead of time if possible — is that you have to report this income, and pay the tax, even if you don't sell the stock. You haven't received any cash; in fact, you paid cash to exercise the option, but you still have to come up with additional cash to pay the IRS. This is one reason advance planning is important in dealing with options.

Withholding.

If you're an employee (or were an employee when you received the option), the company is required to withhold when you exercise your option. Of course the withholding obligation must be satisfied in cash. The IRS won't accept shares of stock! There are various ways the company can handle the withholding requirement. The most common one is simply to require you to pay the withholding amount in cash at the time you exercise the option.

Example: You exercise an option to purchase 1,000 shares for $15 per share when they're worth $40 per share. The company requires you to pay $15,000 (the exercise price for the stock) plus $9,000 to cover state and federal withholding requirements.

The amount paid must cover federal and state income tax withholding, and the employee share of employment taxes as well. The amount paid as income tax withholding will be a credit against the tax you owe when you report the income at the end of the year. Be prepared: the amount of withholding required won't necessarily be large enough to cover the full amount of tax. You may end up owing tax on April 15 even if you paid withholding at the time you exercised the option, because the withholding amount is merely an estimate of the actual tax liability.

Non-employees.

If you aren't an employee of the company that granted the option (and weren't an employee when you received the option), withholding won't apply when you exercise it. The income should be reported to you on Form 1099-MISC instead of Form W-2. Remember that this is compensation for services. In general this income will be subject to the self-employment tax as well as federal and state income tax.

Basis and holding period.

It's important to keep track of your basis in stock because this determines how much gain or loss you report when you sell the stock. When you exercise a nonqualified option your basis is equal to the amount you paid for the stock plus the amount of income you report for exercising the option. In the example we've been using, your basis would be $40 per share. If you sell the stock at some later date for $45 per share, your gain will be only $5 per share, even though you paid just $15 per share for the stock. The gain will be capital gain, not compensation income.

For certain limited purposes (particularly under the securities laws) you're treated as if you owned the stock during the period you held the option. But this rule doesn't apply when you're determining what category of gain or loss you have when you sell the stock. You have to start from the date you bought the stock by exercising the option, and hold for more than one year to get long-term capital gain.

Other methods of exercise.

The description above assumes you exercised your nonqualified option by paying cash. There are two other methods of exercising options that are sometimes used. One is the so-called "cashless" exercise of an option. The other involves the use of stock you already own to pay the exercise price under the option. These methods, and their tax consequences, are described in the pages that follow.