The Dos and Don'ts of Employee Stock Options

Develop an investment strategy for your stock options

Perhaps one of the most important steps to take with regard to employee stock options is developing an overall investment strategy for them rather than winging it. In particular, as you embark upon this effort, ask yourself: How much money are you willing to put at risk when it comes to purchasing these stock options?

"Assume you're going to lose all of the money," says Glasser. "How much could you lose and not impact your lifestyle or impact yourself psychologically?"

Start by calculating the total exercise cost for your options and compare this to the amount of cash you have at hand and are willing to lose in a worst-case scenario, says Glasser. If you do not have the funds available but still want to exercise your options, talk to a financial advisor about some creative solutions that might be available.

Understand tax implications

It's also critical to be clear about the taxes you may be subject to when exercising employee stock options. To develop a full grasp of this issue, you need to know exactly what type of stock you have.

Companies offer two kinds of stock options—nonqualified stock options (NQSOs), which are more widespread, and incentive stock options (ISOs), which have some tax advantages but also come with increased complexities. Before making any decisions or taking any action with regard to employee stock options, find out exactly which camp you fall into.

For instance, as Forbes explains, ISOs qualify for special tax treatment from the IRS. This includes not being subject to Social Security, Medicare, or withholding taxes. There are, of course, some criteria involved in qualifying for this special tax treatment, including the ISO only being granted to employees—not directors, consultants, or contractors, among other things. In addition, in order for an employee to retain the ISO special tax benefits after leaving a company, the ISO must be exercised or sold within three months of the date of departing the company. However, exercising ISOs might trigger what's known as the Alternative Minimum Tax (AMT), so be sure to talk to a tax professional if you have any questions.

When it comes to exercising NQSOs, on the other hand, you will pay taxes—and the transaction is reported on your IRS Form W-2. You pay ordinary income taxes when you exercise the options and capital gains when you sell the shares, says Investopedia. The exact formula for determining the amount that you pay taxes on is somewhat detailed, so you'll want to engage a professional to walk you through the key points.

The key takeaway here with regard to employee stock options and taxes is this: Understand the tax implications of the type of stock you have.

"It's important to have a tax strategy," explains Railey. "The easiest approach is to plan early on, because there are so many choices, and people are shocked by the tax implications."

If you're unsure, don't guess—seek insight from a professional

When it comes to investing and how to handle stock options and their complexities, it's better to be safe than sorry. If you have questions about any element of the process, it's best to find a professional who can help.

"You really need to interview and identify a competent accountant," suggests Railey. "Often the best ones usually come from a referral, perhaps from a colleague or executive who has experience filing this kind of tax return."

Employee Stock Purchase Plans

Unrelated to ISOs and NQSOs, some companies offer an employee stock purchase plan (ESPP). These programs are far more straightforward and can also prove valuable.

As part of an ESPP, employees may be able to purchase company stocks at a discounted price; to do so, deductions are made from your paycheck each pay period (the amount taken from your pay to contribute to the plan is determined by you when you join the ESPP).

These deductions are set aside and allowed to accumulate or build up until a pre-specified stock purchase date. On the purchase date the accumulated money is used to buy company stock.

The beauty of this type of program is that the stock is being made available to you as the company employee at discounted price. In some cases, the discount can be quite significant—as much as 15 percent below market value.

"We always encourage people to enroll in this type of plan if they have the opportunity," explains Railey. "Assuming the stock has the ability to appreciate over time, the discount is essentially extra compensation from the company."

The IRS restricts the total dollar amount of ESPP purchases to $25,000 per calendar year, says Investopedia.

There are no taxes due on this particular type of stock—until you sell it. When ESPP stock is sold, the discount you were given by your employer on the original stock price is taxed as ordinary income, says Investopedia. In addition, any gains above and beyond that price will be taxed at the applicable capital gains rate.

Despite the apparent benefits, often, employees fail to sign up for ESPP offerings because these sorts of programs get lost in the shuffle of onboarding for a new job. Though the tide may be changing on this front. As of 2021, according to the National Center for Employee Ownership, there's about 6,600 employee stock ownership programs, which cover more than 14 million participants. Since the start of the 21st century, there has been a decline in the total number of these types of stock plans but an increase in the number of participants. About 11 million of those participants buy shares in their employer through employee stock purchase plans.

If you do have access to an ESPP and you went to the trouble of signing up, Railey suggests leaning into this perk and buying as much discounted stock as is allowed—though Investopedia suggests making sure your overall portfolio of investments is balanced and that you do not have more than 10 to 15 percent in any one company (to protect yourself against a downturn).

Glasser offers a similar caveat, suggesting you consider the prospects of a company when deciding whether to enroll in a stock purchase program.

"If you don't think the company is going to do well, you might consider not participating," he explains. "But if you're offered an ESPP, make an affirmative decision not to participate, or to participate. You shouldn't just not participate because you don't know what to do."