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How Non-Qualified Stock Options Work
Posted By Jim On 10/29/2008 @ 12:32 pm In Investing | 7 Comments
My wife works in a management position at a local biotech startup and in that role she’s granted non-qualified stock options from time to time. I wrote about pre-IPO stock options  over two years ago but since then she’s received “post-IPO” non-qualified stock options. Since it’s getting to be the end of the year, I’m doing some research as to how the capital gains works and it turns out that stock options are pretty easy to understand.
First, there are incentive stock options and non-qualified stock options. There are several differences but the one that really matters is how they are taxed. This article will focus on non-qualified stock options, non-qualified referring to how they are not qualified for special treatment (incentive stock options are treated differently).
How my wife’s stock options work is that she’s awarded X shares, say 1000 shares, at a grant price, say $10.00, on a certain day. The shares vest over a number of years, say 4 years. So next year she gets 250 shares at $10, the year after she gets another 250 shares at $10, etc. She currently has the options but she can’t exercise them until they vest. That’s the basic vocabulary.
How are these taxed? When you exercise the option, 250 shares at $10, you are immediately taxed on the difference between the market price and your exercise price ($10). If the market price is $12 when you exercise, then you will immediately be taxed on $500 ($2 x 250 shares) of capital gains. You can hold the shares, you can sell them, but you are already on the hook for $500 of capital gains. From there on for tax purposes, it’s as if you bought the shares at $12.
So I had this chat with my wife and the first thing she thought of was to exercise the stock options when the stock is at its lowest value. On the face of it, it seems to make sense. The smaller the difference between your grant price and the market price, the less you are taxed. However, you earn less too. It doesn’t matter which tax bracket you are in, you are taxed less than what you earn. In the highest tax bracket of 35%, you keep 65 cents on the dollar; you want the price to be as high as possible before you exercise. The key is to maximize income, not minimize tax.
In reality, you balance your need for the money with the market price of the stock. You always want to exercise at the highest price possible but you have to balance that with whether you need the money or when the options expire. When you exercise, you want to sell immediately. There is no benefit to holding onto the shares. If you wanted the shares in the first place, you could’ve bought them on the open market. By keeping your shares, you run the risk of being taxed on income you will never realize.
This is all based on my own web research, I’m not a tax professional so please consult with a tax accountant or attorney before making any decisions.
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 pre-IPO stock options: http://www.bargaineering.com/articles/introduction-to-pre-ipo-stock-options.html
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