Has anyone ever asked you what your income is and they mean your salary? Well as a high income earner or a corporate executive, you know your salary is only one piece of your total income, or total compensation. You likely have employer stock too, such as restricted stock units or non-qualified stock options.
Hi, I’m Michelle with Financial Design Studio and today that’s what we are talking about. Non qualified stock options, or NQSOs, are just one piece of your whole compensation package.
What I want to touch on are a few of the key definitions that you need to know that affect your stock options. We’re going to go through an example so you can see this in action and then we are going to step back and understand the big picture.
Non-Qualified Stock Options Definitions
You might be starting at a new company or you might have been here for a while and now your company is offering you these NQSOs. This could be because you are moving up into a greater role. Stock options are typically reserved for a specific type of employee.
I’m talking specifically about non-qualified stock options. There is another type of stock option that you could be awarded, an incentivized stock option or ISO. We are going to touch on these in a different video.
There is a difference; a non-qualified stock option is titled that because it does not receive preferential tax treatment from the IRS. You are going to see this in a couple different ways.
What is a Grant Date?
First , the grant date. This is simply the date at which your employer will specify a number of shares to be awarded to you at a specified price. They might say, ‘today you are being given 100 shares at a strike price of $100.’ That is how these might be awarded.
At this point, you might be thinking, ‘great I’ve been given something, but are there any tax consequences I need to know about?’ The answer here is, no. Simply being awarded these shares does not have a tax consequence at this time. There is nothing you need to do here.
Now, you might be subject to a vesting schedule. Let’s say they give you these 100 shares, but you get them over a period of four years. So, maybe you will own 25% per year, for the next four years. There are lots of different vesting schedules, but you will probably be subject to one.
What is an Exercise Date?
Next, we need to know the exercise date. This is the date when you will purchase the stock from your employer. They said they would give stock to you for a certain price. Now, you exercise those shares. This means you will actually purchase the stock from your employer, at that price, for that amount.
When you actually purchase that stock, consider that they are giving you money. They are giving you income, or a piece of your overall compensation package. So you are receiving something when you purchase their stock.
Now you got it at a great price. You didn’t have to buy it for the value you are receiving it for. At this point, there is a tax implication you need to take care of because you received something. You need to recognize this as W-2 income. Just like when you are paid, you get a W-2, you need to recognize this income on your W-2.
You do this by finding the difference between the value on the date of exercise and the price that they granted it to you at. This is why those definitions matter. Now just wait, we are going to go through an example because I know this can start to get confusing.
What is the Sale Date?
The last definition we want to understand before we go through this example is the sale date. So you’ve purchased the shares from your employer that they said you could have. Now, let’s say sometime in the future, you decide you want to sell your shares.
You need to recognize the capital gain between the value at the exercise date, when you purchased it, and the value at the sale date. This will be the fair market value, at the date sold.
With all of these, there are very important details. Now that you know the definitions, we can walk you through an example. This will help you see what this looks like and consider how this could apply to your situation.
Non-Qualified Stock Options Timeline
Alright I’ve got a timeline here so we can walk through what these definitions mean in real life when they happen. Let’s assume on January 1, your company grants you 100 shares of their company stock. We are going to assume this is granted to you at $100 per share.
The Grant Date
Remember this grant date is just simply your company saying, ‘hey, great job. We will award you 100 shares, at $100 per share at some point in the future.’ There are no tax consequences, and nothing you need to do at this point because you haven’t really gotten anything.
The Exercise Date
Now you might be subject to the vesting schedule. Let’s assume August 1 of that same year you can buy those shares–they are available to be exercised. So now, we are actually going to say that in August, we’ve got an exercise date. This is when we actually purchase these shares for $100 per share. We are going to assume the fair market value at the exercise date is $120 per share.
If we look back at our definition, we see we are going to have to recognize W-2 income. So just like we get for our salary, we get a W-2. We are going to get a W-2 that shows the difference between the $120 fair market value and $100 exercise date value. That’s a difference of $20 a share, at 100 shares.
This gives us $2,000$ of W-2 income that you are going to have to do something with. Now this is W-2 income that you will pay payroll taxes and income taxes on, as if you had earned $2,000.
The Sale Date
Alright now, you own the shares. Let’s fast forward and say on December 1 of the following year, you’ve decided that you actually want to sell these shares. This is our sale date. Let’s say on this date, the shares have increased in value to $150 per share. So now, you’ve got this new time horizon between exercise date and sale date that will be taxable.
The difference between $150 fair market value and -$120 exercise date value give us $30. Now 30 multiplied by 100 shares gives us $3,000. The difference here is it’s not W-2 income. These are actually capital gains.
Paying Capital Gains
The way that you pay taxes on capital gains is based on the time horizon of how long you held it. We owned it from August of the first year to December of the second year. We held it longer than one year, so this is considered a long term capital gain.
If we had held it less than a year, then we would have had a short term capital gain. There is a difference there in how much income tax you pay and the income tax rate you pay it at. These are all pieces you need to be aware of.
What is really helpful is you can see in these time frames, you’ve got one transaction that happened at the exercise date that has one tax implication. Then you can see, from what you decide from that point, you’ve got a second tax implication at the sale date.
Tax Planning for Non-Qualified Stock Units
Now a lot of times when we talk about tax planning, we are focusing on the long term. Think about high income earners and corporate executives; you will become near retirees and retirees one day. So we don’t want to just look at the short term impact, we want to look at the long term.
That will help us decide when we should sell these stock options. The date will be based on a lot of factors. Maybe you want to give money away, maybe you need money to fund a goal like your kid’s education or your retirement, or something along the way for retirement like buy a second home or moving out of state. There are so many different goals and timings for what you need to happen. This is why tax planning is such a big part of what we do.
We’ve talked about non-qualified stock options, which are just one piece of your total compensation! I just want to point you to our tax savings downloadable. In it, we explore some strategies you can deploy to save more in all areas of your income. Take a look at that, it’s got some really helpful information, tips, and strategies that you can implement as a high income earner, corporate executive, or near retiree. If you still have questions, feel free to reach out to our team to find answer!
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Michelle Smalenberger, CFP®
I have a passion for helping others develop a path to financial success! Through different lenses on your financial picture, I want to help create solutions with you that are thoughtful of today and the future. I have seen in my life the power of having a financial plan while making slight changes of direction from time to time. I believe you can experience freedom from anxiety and even excitement when you know your finances are on track.