Stock Options 101: What You Need to Know About ISOs, NQSOs and Restricted Stock

Eric M. Solve, CFP®, EA
Eric M. Solve, CFP®, EA
stock options

Employee stock options are a common form of equity compensation that companies use to attract and retain the best talent. Stock options give you the potential to share in the growth of your company’s value with little risk to you – until you exercise your options, that is. There are multiple types of stock compensation, and each is granted, managed, and taxed in its own way. In this article, we’ll touch on some of the differences between non-qualified stock options (NQSOs), incentive stock options (ISOs), and restricted stock so that you can maximize your stock options, guard against unfortunate tax surprises, determine who you will need to consult with, and plan accordingly.

Non-Qualified Stock Options (NQSOs)

Non-Qualified Stock Options are the most common form of stock incentive. They may be granted to employees, officers, and directors, as well as to contractors and consultants, too. The “non-qualified” in NQSO refers to the fact that this type of stock option does not qualify for special favorable tax treatment under the IRS Code.

You will pay taxes on your NQSOs at the time of exercise. From a tax perspective, the exercise spread, or difference between the fair market value of the stock at the time of exercise price and the grant price, is considered compensation income. It will be reported on your W-2 in the calendar year you choose to exercise your options. Your company will withhold income tax, Social Security, and Medicare taxes when you exercise, too.

If/when you decide to sell your shares of company stock, either immediately or after a certain holding period, the gain (or loss) will be taxed as long or short-term capital gains/losses, depending on the holding period. You would report the sale on Form 8949 and Schedule D of your IRS 1040 tax return.

Incentive Stock Options (ISOs)

Unlike NQSOs, incentive stock options do qualify for special tax treatment. They are not subject to Social Security, Medicare, or withholding taxes. However, it should be noted that they must meet rigid tax code criteria. ISOs also differ from NQSOs in that they cannot be granted to contractors or consultants – only to employees.

There is a $100,000 limit on the aggregate grant value of ISOs that vest (i.e. become exercisable) in any calendar year. Additionally, if you leave the company, you must exercise your ISOs within 90 days in order to retain your tax benefits.

If you want to incur favorable, long-term capital gains tax on appreciation after exercising your ISOs, you will need to hold the acquired shares for at least two years from your date of grant and one year from the date of exercise. Holding for a shorter length of time will mean any appreciation is taxed at your ordinary income tax rate – generally, higher than the long-term capital gains rate. However, it’s important to note that if you have paper gains on shares you acquire from ISOs and you hold them beyond the calendar year in which you exercised the shares, you could be subject to the alternative minimum tax (AMT). In theory, this could pose a problem if you are hit with the AMT on gains only to see the company’s stock price plummet, leaving you with a significant tax bill on income that has, essentially, evaporated.

One of the most meaningful decisions you’ll need to consider when you are granted NQSOs or ISOs, is whether or not to make a Section 83(b) election. The 83(b) election allows you to be taxed on the value of the shares at grant, rather than at vesting. This decision is entirely up to you and is often best made with the guidance of a financial professional as there are many things to consider (e.g. the cost of making the election, tax ramifications, the potential pros and cons of making the election, filing requirements and deadlines, etc.)


SEE ALSO: Strategies for Optimizing Employee Stock Options


Restricted Stock

Not all companies grant stock options, and it’s possible you’re a recipient of restricted stock instead. Although restricted stock units (RSUs) do not offer the same flexibility from a timing and tax planning perspective that NQSOs and ISOs do, they are quite common.

The value of NQSOs and ISOs depends on how much – or whether – your company’s stock price rises above the price on the date it was granted to you. By contrast, restricted stock maintains value at vesting regardless of whether the stock price has increased, remained the same, or dropped in price since the grant date.

Restricted stock is considered a supplemental wage by the IRS, so it follows the same tax rules and W-2 reporting that apply to NQSOs.  As RSU’s vest – either after a passage of time or at the achievement of a performance goal – you may have a choice of tax-withholding methods, or your company might automatically withhold (sell) vested shares to “cover taxes.”  Oftentimes, the withholdings are not enough to cover the individual’s actual tax liability; good tax planning can avoid underpayment penalties and interest.

The certainty tied to restricted stocks’ value can be appealing, especially if you have lower risk tolerance. NQSOs and ISOs have great upside potential, but they’re inherently risky in that they can be underwater – the term used for when their market price of an option is lower than the exercise price.

Of course, to receive the value of the restricted stock, you must remain employed until your shares vest. While you can exercise vested stock options for several months after leaving a company, as mentioned above, it’s common for unvested grants of restricted stock to be forfeited immediately upon termination of your employment. In this sense, restricted stock is an effective “golden handcuff” to keep you at your company longer.

More Differences Between Stock Options and Restricted Stock

  • NQSOs and ISOs require you to decide when to exercise and what exercise method to use, but it’s not so with restricted stock.
  • Stock options and restricted stock also differ when it comes to dividends. Stock options very rarely carry dividend rights. However, the restricted stock usually entitles you to receive dividends whenever they are paid to shareholders.

A Trusted Partner in Making the Most of Your Incentive Compensation

At Wade Financial Advisory, we offer a depth of knowledge and breadth of experience in helping you manage your money and invest it wisely, including your equity compensation benefits. We offer personalized, relationship-based service, so reach out for an introductory conversation today so we can get to know you and your unique financial goals.

This communication contains the opinions of Wade Financial Advisory, Inc. about the securities, investments and/or economic subjects discussed as of the date set forth herein. This communication is intended for information purposes only and does not recommend or solicit the purchase or sale of specific securities or investment services. Readers should not infer or assume that any securities, sectors or markets described were or will be profitable or are appropriate to meet the objectives, situation or needs of a particular individual or family, as the implementation of any financial strategy should only be made after consultation with your attorney, tax advisor and investment advisor. All material presented is compiled from sources believed to be reliable, but accuracy or completeness cannot be guaranteed. PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS. INVESTMENTS BEAR RISK INCLUDING THE POSSIBLE LOSS OF INVESTED PRINCIPAL.

Wade Financial Advisory, Inc. is an investment adviser registered with the Securities and Exchange Commission. Registration of an Investment Advisor does not imply any level of skill or training. A copy of current Form ADV Part 2A is available upon request or at www.advisorinfo.sec.gov. Please contact Wade Financial Advisory, Inc. at (408) 369-7399 with any questions.

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