Options are contracts that give investors the right to buy or sell shares at a set price within a specified period of time. They’re often used by companies to attract and retain talented employees, but there are also risks involved in using them.
If you get stock options as part of your compensation package, make sure you understand how they work. Here’s what you need to know.
When Should I Buy or Sell?
To buy or sell options, you must first determine whether it makes more sense to buy or sell them at this point in time. This decision will depend on several factors, such as which stock you own, the set purchase or sale price built into the contract (aka strike price), the cost of the options, and the expiration date.
How Do They Work?
An incentive stock option (ISO) gives its holder the right to purchase 100 shares of their company’s stock at a set price within a specified period of time.
If the share price rises above the strike price during that time, the owner of the ISO is able to buy the stock at a price that’s lower than what it’s selling for on the market, which is why these can be valuable.
How Much Can I Earn?
The value of an ISO depends on several factors, including the company’s performance, the market price of the underlying stock, and the length of the contract. However, there are some general guidelines that apply to most ISOs.
The amount you’ll earn depends on how well the stock performs that you have a set purchase on.
If you receive ISOs from your employer as part of your compensation, these give you the right to buy your company stock at $100/share no matter what the stock is selling for.
How does the stock appreciating above your fixed purchase price benefit you?
If the stock appreciates to $200/share… you could exercise your ISOs, buy the stock for $100/share and immediately sell them for $200, thereby getting a 100% rate of return with little risk.
An example that demonstrates how stock options work
If a car dealership told you that by paying them $100, you could lock in your purchase price for a car at $20,000, indefinitely.
10 years later, the car is selling for $40,000 and you decide to buy the car for the $20,000 agreed to in the contract and immediately sell it for $40,000.
How much did you earn? $40,000 – ($20,000 + $100) = $19,900. This is exactly how making money with options works.
The hard part is, exercising and selling the stock can both be taxable and the taxes change depending on a variety of factors.
Is This A Good Time To Buy Or Sell?
This is the hardest part of using options because no one knows what the stock is gonna do for sure. We can speculate and say xyz company is going to do well but we could be wrong and could waste thousands of dollars.
Most people exercise their options when it’s close to expiring because it lessens their risk so long as they don’t have a semi-ridiculous amount of ISOs (which require more thought) and don’t expect to get laid off between now and then. Before exercising your ISOs or selling the stock you get subsequently, talk to a financial planner or a tax professional.
Do Incentive Stock Options Always Make Money?
No, but this doesn’t mean they’re not potentially life-changing.
Many people prefer RSUs (Restricted Stock Units) over ISOs because they’re guaranteed money, however, companies tend to be more generous with ISOs than RSUs because of the risk involved. If you’re bullish on the future of your company, ISOs could be more life-changing and carry with them a more significant impact on your future than RSUs (assuming you’re right).
If you’re not, consider negotiating for more RSUs or compensation when you’re offered a job. This will be a more sure thing and in doing so, could also be more beneficial if you’re right.
ISOs (Incentive Stock Options) are a common form of compensation given by companies to their employees. These options provide employees with the right to purchase company stock at a discounted price. This article will discuss the key aspects of ISOs that employees should know.
Alternative Stock Options
In addition to ISOs, companies may offer other types of stock options to their employees, such as non-qualified stock options (NSOs) and restricted stock units (RSUs). Although these options may offer similar benefits to ISOs, they differ in terms of tax treatment and other factors.
The Impact of AMT on ISOs
The Alternative Minimum Tax (AMT) is an additional tax that some people may have to pay in addition to their regular income tax. It’s designed to ensure that people who have high incomes or who take certain tax deductions pay a minimum amount of tax.
AMT can impact Incentive Stock Options (ISOs) because the tax treatment of ISOs is different from other types of stock options. When you exercise ISOs, you may be subject to the AMT instead of the regular income tax. This can happen if the fair market value of the stock at the time of exercise is higher than the exercise price, which is often the case with ISOs.
The AMT can increase your tax liability, which means you may owe more taxes than you would if you were only subject to the regular income tax. This is because the AMT limits certain deductions and credits that you may be able to claim on your regular income tax return.
To avoid being caught off guard by the AMT, it’s important to understand your tax situation and consult with a tax professional before exercising your ISOs. They can help you determine whether the AMT applies to you and how to plan for it.
Holding Period for ISOs
To qualify for favorable tax treatment, ISOs must be held for a specific period known as the holding period. Typically, the holding period for ISOs is two years from the grant date and one year from the exercise date. If the shares are sold before the end of the holding period, the employee may be subject to ordinary income tax rates and potentially the AMT.
Employee Stock Purchase Plans (ESPPs)
Employee Stock Purchase Plans (ESPPs) are another type of employee benefit that allows employees to purchase company stock at a discounted price. ESPPs differ from ISOs in several ways, including the fact that they are available to all employees, not just executives, and they do not have a holding period requirement.
Grant Agreements for ISOs
The grant agreement is a key document that outlines the terms and conditions of the ISO grant. It should include information such as the number of shares granted, the exercise price, the vesting schedule, and the expiration date. It is important for employees to carefully review the grant agreement to understand the terms of their ISO grant.
Selling ISO Shares
When selling ISO shares, employees must determine the tax basis of the shares, which is typically the exercise price. They must also determine the holding period of the shares to determine the tax rate that applies to the sale. It is important for employees to report the sale of ISO shares on their tax return to ensure compliance with tax laws.
Risks Associated with ISOs
ISOs come with risks. For example, ISOs are subject to market risk, which means that the value of the underlying stock can fluctuate. Additionally, ISOs may be subject to liquidity risk, which means that the shares may be difficult to sell if there is not a ready market. Finally, if an employee leaves the company before the shares are vested, they may forfeit their ISO grant.
In summary, ISOs can be a valuable employee benefit, but employees need to be aware of the potential tax implications, holding period requirements, and risks associated with these options. By understanding these key aspects, employees can make informed decisions about their ISO grants and maximize the benefits they receive.