9 Things To Know about Non-Qualified Stock Options

Non-qualified stock options (NQs) are a common form of compensation provided to certain employees as part of a compensation package. If you have access to these perks, they give you the opportunity to potentially profit from the rising value of the company’s stock should the company’s stock price rise over a specified time.

If you find yourself on the receiving end of NQs, you need to understand exactly what non-qualified stock options are and how they work, including how they could impact your income taxes, investment risk, and financial planning goals.

Here are nine key items you need to know about non-qualified stock options.¹

1. Non-qualified stock options are not taxed at grant

When you have NQs, you need to know the grant date. That’s the date when you get your company stock options.

Receiving NQs is generally a non-taxable event. You do not owe anything in federal tax when you receive them, nor are you required to report anything for federal tax purposes.

Being granted these options simply means your company gives you the right (via the option) to buy a set number of shares a set price (exercise price) for a specified period of time. 

2. Non-qualified stock options are not taxed when they vest

The vesting date of NQs is another important piece of information you need to know about your options. The vesting date of non-qualified stock options is typically the first date you can exercise them (exercising is purchasing the stock at the set exercise price).

You are not required to exercise on the vesting date, but you can if you so choose on any date after your NQs vest (until the NQ expires, see below).

You generally can’t exercise the right to buy the shares before they vest. In regards to unexercised NQs, you won’t owe federal taxes when your options vest nor do you need to report anything for federal income tax purposes prior to exercise.

3. You will owe taxes when you exercise your NQs

Neither the grant of NQs nor the vesting of those options will trigger a taxable event. But when you actually exercise your non-qualified stock options, the underlying shares will be subject to federal tax. Exercising creates a reportable event for income tax purposes.

Specifically, the amount that will be taxed (commonly known as the bargain element) is equal to the following formula:

Number of shares exercised * (market price at exercise – exercise price)

This bargain element is subject to compensation tax withholding, including federal income tax withholding, federal Social Security and Medicare taxes, and in some cases, certain state and local withholding taxes. This means the bargain element will be taxed similarly to your other compensation income.

4. Withholding amounts will vary when you exercise

If you exercise your options, you need to be aware that you could end up with a substantial amount of income tax withheld. The specific amount of tax you owe will be subject to the number of shares you exercise and the spread between the market price at exercise and the exercise price.

Using a simple example to illustrate, let’s assume you have 50,000 stock options with an exercise price of $1 and the market price at exercise is $50. Assume you exercise the options.

Following our formula above, we can calculate the following:

Taxable amount: 50,000 * ($50 – $1) = $2,450,000

Assuming a flat income tax withholding rate of 37%, your estimated income tax withholding would be $906,500.

5. You may have several options to pay the tax

Most of us don’t have $906,500 sitting around in our piggy bank that we can use to cover the tax withholding. Thankfully, there are several options that can help alleviate the tax pain, depending on the terms of your NQ grant agreement or the company’s equity plan document.

One of the most common methods is known as a sell-to-cover. A sell-to-cover exercise allows you to simultaneously exercise and sell some of your shares to cover the cost of your tax bill, including the tax withholding.

It’s important to note that the cash generated from a sell-to-cover that is used for tax withholding may or may not be enough to cover the actual tax bill. You may want to work with a tax advisor to better understand your tax situation.

Continuing our general example from above, we can calculate an estimated number of shares necessary to sell-to-cover the tax bill using the following formula:

Number of shares to sell = tax liability / market price at exercise

Using our numbers, we know that $906,500 / 50 = 18,130 shares.

In this scenario, an immediate exercise and sell of 18,130 shares would generate the cash required to cover the tax liability. It would also leave you with 31,870 shares, valued at $1,593,500.

6. You may owe even more tax later

If we kept using our earlier example, you’d retain 31,870 shares with a value of $1,593,500 after doing your sell-to-cover. The amount reported as income from the NQ exercise on your W2 can help determine the cost basis of the remaining shares, which is important because your cost basis will determine any future capital gains or losses upon disposition of the shares.

Over time, the value of the shares you keep will likely fluctuate with the markets. Any future gain or loss (over or under the cost basis) will be taxed upon disposition of the shares, subject to short-term or long-term capital gains rates.

Should you hold the shares for longer than one year from the date of exercise, any gains will be taxed as a preferential long-term capital gain. If you hold for one year or less after the exercise date, ordinary income tax rates apply.

The best answer on what to do here is one that is customized to you and your needs. Advice from a tax advisor and a detailed financial plan can help determine which strategy is best for you.

7. Your options will expire if unexercised

Non-qualified stock options are not a right into perpetuity. They come with an expiration date, which is often ten years from the grant date. If you don’t exercise your options before the expiration date, your options will usually no longer be available — as well as any value associated with them.

It’s important to know the expiration date of your stock options and to plan accordingly. If the expiration date comes and goes without an exercise, it’s possible you will forfeit any subsequent value.

8. There are many strategies for exercising NQs

When it comes to exercising your options, you have a lot of possible choices. The right strategy for you is whichever allows you to meet your goals and objectives.

One potential strategy for exercising your non-qualified stock options is to simply wait until they’re about to expire.

You can generally identify this is how much you’ll get today, you’ll know how much tax you owe — and you also know if you keep waiting past the expiration date, you’ll get nothing. Clarity in terms of certainty is, for many, a clear solution.

Another approach may be to exercise your options when the stock price is at its high. But unfortunately, even professional investors find it difficult (dare we say impossible) to easily identify when the stock price is at its high.

A more realistic alternative may be exercising your shares when you have “enough.” Enough may be the amount required to lead the retirement you want to. Or enough may be the amount required to buy the car you’ve been eyeing.

Finding your enough is all about determining what is important to you through goal setting and accountability.

For those looking to automate the process, a rolling exercise—an approach that means exercising a set number of shares each year or a set value each year, can also be a great decision.

Using our example of 50,000 shares from above, a rolling exercise may suggest exercising 10,000 shares per year, for 5 years, on July 1st of each year. This approach removes emotion from the process, manages the tax hit over several years, and averages the price at which you exercise your shares.

Finally, you can have a tax-focused approach. This approach may consider the early exercise of stock options to transition the future growth (if any) of the stock from ordinary income to capital gains.

Ultimately, the most suitable plan may be one that is a combination of the concepts above.

9. Your stock options could be worth less than you hoped

For stock options to have value, the stock price needs to appreciate above the price at which you can buy the shares (exercise price). While this is what anyone with stock options hopes for, it doesn’t always happen.

In fact, it’s possible for the share price to go below the price at which you can exercise your option. If this occurs, your option will be under-water. If your option is under-water and the expiration date comes and goes, your option will expire worthless.

However, the share price might later rise above the exercise price before the options expire, leading to an in-the-money stock option. In-the-money means that you can buy stock via your option at a lower price than the current market price. 

Summing it all up

The nine points above address key “need to know” things about your non-qualified stock options. It’s a nice template to get you thinking about the value they could provide to you if your employer offers them.

The key with non-qualified stock options is to evaluate how the points above (taxation, vesting, financial planning, and investment management) fit into your personal financial plan.

One way to evaluate the “how” is to take a proactive approach to learning as much as you can about taxes, investment management, and financial planning.