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Employee Stock Options

To attract and keep top employees, more companies are offering them employee stock options. If you receive employee stock options as part of your compensation package, careful planning can help you make the most of them.

What Is an Employee Stock Option?

Employee stock options give you the right to buy stock in the corporation that employs you at a specified price – the exercise or “strike” price – at a future time. Usually, the strike price is equal to the stock’s market value at the time the option is granted. You benefit if the value of the stock rises and you sell it for more than you paid for it. Employee stock options usually have an “exercise period” during which you have to buy the stock or lose the options. They also may have a “vesting schedule” that requires you to wait a certain period before you can exercise your option. Employee stock options come in two basic varieties: nonqualified and incentive.

Nonqualified Options

With a nonqualified stock option, you generally owe no taxes on the option until you exercise it. Then, you must report income equal to the difference between the stock’s market value and your exercise price.

For example, if you exercise an option to buy 100 shares of your employer’s stock for $10 per share when the stock is trading at $25 a share, you are considered to have received $1,500 (100 shares @ $15 profit per share) of taxable income that year. You’ll have to pay tax on that income at regular tax rates, which range as high as 39.6%.

Once you exercise your option, you own the shares of stock. You can sell your shares right away or hold on to them and sell later. Returning to the example, you’ll make $1,500 if you sell the stock for $25 a share. Sell it for $35 and you’ll make another $1,000 (taxable as a capital gain). For most investors, the maximum long-term capital gains tax rate on stock held more than a year is 23.8%.

Incentive Stock Options

With incentive stock options (ISOs), you don’t generally recognize any income for regular tax purposes when the option is granted or exercised. Rather, income is recognized only when you sell the stock and, if you meet two requirements, it’s taxed at the lower capital gains rates. Those requirements: You must wait until you’ve had the stock more than one year before you sell and the date of the sale must be more than two years after the date you were granted the option.

Watch Out for AMT

However, with ISOs, you could find yourself subject to alternative minimum tax (AMT) in the year you exercise the option. AMT is intended to prevent people from reaping more than their fair share of benefits when they use certain deductions, credits, and exclusions to reduce regular income tax. The difference between the price you pay for the stock when you exercise an ISO and the stock’s market value at that time is considered an adjustment for AMT purposes. If you’re subject to AMT, you effectively have to pay tax on this “profit” even though you haven’t yet sold your stock.

A common employee stock option strategy is to hold on to options as long as the stock price continues to rise. And waiting until you have plans for the money – college expenses, a new home, or retirement – can keep you from spending any profits frivolously. Talk with your professional financial advisor. He or she can help you integrate your employee stock options into your overall investment program.

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