Investing5 min read

What are employee stock options (ESOs) and how do they work?

What are employee stock options and how do they work HumbleCompanies offer a variety of perks to attract and retain top talent. While it’s common to find jobs with retirement plans and health insurance, some businesses also offer employee stock options (ESO).

These stock options give employees the right — but not the obligation — to buy a fixed number of shares at a designated price, also known as the strike price. ESOs can increase an employee’s total compensation while offering tax advantages. Understanding stock options and how they work can help you decide if an employer’s ESO package is right for you.

How do employee stock options work?

Employee stock options let you buy shares at the strike price by a predetermined expiration date. For example, owning stock options with a strike price of $50 allows you to pay $50 for a fixed number of shares even if the current market price is $100. If you choose to exercise the options, you’re opting to buy shares, usually for a profit.

While you can increase your earning potential with employee stock options, you’ll need to take note of expiration dates and vesting schedules. In contrast to publicly traded stock options that can expire within a few days or weeks, employee stock options usually expire up to 10 years after they are issued. After expiration, the options are worthless, and you lose the chance to buy shares at the strike price.

ESOs also have clauses that require you to work for the company throughout a vesting period to receive the options. Employers use this strategy to retain top talent and discourage employees from switching jobs before their options vest.

Vesting schedules can depend on the passage of time or the achievement of a milestone. For example, if your employer grants you 4,000 stock options, you might only earn the right to exercise 1,000 vested options for each year of employment. Milestone-based vesting schedules may grant options based on a deliverable, like a product launch or achieving a key performance level. Hybrid vesting schedules may combine time-based or achievement-based vesting periods.

Understanding stock option agreements

Stock options can contribute significantly to a compensation package and help you build wealth, especially if the company grows. If you’re negotiating job offers, you may need to compare incentive plans structured with different vesting periods and types of options. It’s also worth considering the risk of the shares falling below the strike price, at which point they would lose their value. These factors can influence how much you make from employee stock options and what you receive if you leave the company early.

Guidance from a seasoned financial expert can help you navigate the complexities of stock options. FinanceHQ matches you with a financial advisor to advise how to negotiate stock options and evaluate incentive plans offered. It’s helpful to connect with a tax professional before exercising options to determine how exercising the contracts may impact your tax bill.

How are employee stock options taxed?

As with any income, ESOs are subject to taxation, although the rules differ according to the type of ESO. Common employee stock options include:

  • Non-qualified stock options (NSOs)

  • Incentive stock options (ISOs)

NSOs generally receive less favorable tax treatment than ISOs. When you exercise an NSO, the difference between the market value of the stock and the strike price gets taxed as ordinary income. For example, if you have a $20 strike price for your options and you exercise them when their market value is $30 per share, you will owe tax on $10 in ordinary income for each share you acquire. Federal, state, and local income taxes — in addition to payroll taxes — may also apply.

Employees with ISOs do not pay taxes when they exercise their options. However, upon exercise, ISOs may be subject to an alternative minimum tax (AMT) applicable at certain income thresholds.

Both types of options are subject to capital gains taxes if you sell shares at a profit. For example, if your cost basis for the stock is $30 per share and you sell shares at $50 per share, you will pay capital gains tax on the $20 per share gain. Since capital gains rates are usually lower than ordinary income rates, ISOs are considered to have better tax treatment.

The timing of your transactions matters. If you hold the shares for less than a year, you get taxed at a higher short-term capital gains tax rate. However, by holding shares for over 365 days, you qualify for the more advantageous long-term capital gains tax rate. You may also be able to sell shares in years when you have less taxable income and are subject to a lower tax bracket to reduce tax obligations.

Work with a professional

It takes both time and effort to excel in your career in order to put yourself in a position to obtain employee stock options, but they can help you earn more in the long run. Understanding how stock options work for employees and setting long-term financial goals can help you build wealth and make your retirement more comfortable.

Don’t let uncertainty hold you back from unlocking the true potential of your employee stock options! If you need any guidance, FinanceHQ can connect you to a trusted advisor to navigate employee stock options and help you make informed decisions about your financial future. Take control of your financial journey today by working with a certified financial advisor.

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Anna Yen
Written byAnna YenContributing writer

Anna Yen is a CFA charterholder, financial wellness expert, writer, and investor at FamilyFI.