I’ve spent the start of 2021 taking a close look at how equity compensation works, and how it can work better, for those who have the option. The rules, benefits and tax implications around the many types of equity compensation can be complicated, and it pays to understand how your own personal financial situation and goals play into how you should make decisions. As I close out this short series, I’m diving into NQOs (Non-Qualified Stock Options).
How do NQOs work?
NQOs are unrestricted in many ways. For starters, they can be offered to anyone (contractors, vendors and other third parties), not just full-time employees. They allow the purchase of stock at a fixed price after a defined period of time, often up to 10 years, with the hope that when they are exercised the market price of the stock will have risen so the buyer gets the stock at a nice bargain. Unlike Incentive Stock Options and Restricted Stock Units, NQOs are not restricted by waiting periods, profit or price. But keep in mind they do have an expiration date, so make sure you read your grant documents for all the information.
How should I pay for my NQOs?
There are a couple options to consider for how to pay for your stock purchase. Let’s say you were granted 1,000 NQOs at a “strike” or “grant” price of $20 per share. After your vesting date passes, the fair market value of the stock is $50 a share. If you want to pull the trigger and buy, you could use your own cash and spend $20,000 to get $50,000 worth of stock — 1,000 shares total. Or you could undertake a “cashless exercise” and not spend any money out-of-pocket. In essence, you use a portion of your shares to offset the cost. In the example we’re using, you’d sell 333 shares to cover your purchase. You’d be left with 667 shares at a value of $33,350.
Which should you choose? It depends on whether you have the liquidity to cover the cost out of pocket — and also whether you want to hold onto the shares for the long-term because you believe their value will increase. If you’ll be selling right away, at the same price as the fair market value when they are exercised, there would be no tax benefit to paying cash vs. via a cashless exercise.
Do I have to exercise all of my shares at once?
You do not have to exercise all of your options at once. By exercising your options at different times, and in different tax years, you can reduce your costs and spread out the tax burden.
Should I sell or hold my shares?
Multiple factors play into whether you should sell or hold your shares. If you sell immediately upon purchase, you will not be subject to capital gains taxes, and you can reinvest in other stocks to avoid over-concentrating your portfolio. Note: Your profit from your purchase ($30,000 in the example above) will be taxed at your ordinary income rate (learn more about this below).
If you believe the stock will perform well, and are OK with holding the percentage you own in one stock given your overall portfolio holdings, you can hold onto the shares. If the stock price rises another $5 and you sell before a year passes, you’ll be taxed on the profit at the short-term capital gains rate (your ordinary tax rate). If the stock price is up $5 after a year, and you sell, you’ll pay the long-term capital gains rate.
What are NQO tax implications?
First the good news: There are no tax implications for NQOs upon the grant date, or upon vesting date (the first date you can exercise them). You’ll see tax implications only after you exercise the options and later sell the stock.
And some bad news: NQOs are not tax-advantaged like some other equity compensation methods. Once you exercise your stock option by purchasing stock, the difference between the fair market price of the stock ($50 in the example above) and the strike price ($20 in the example above) is subject to taxation at your ordinary tax rate. Your company must report that differentials on your W-2 in the year you exercise your options.
It’s important to get a copy of your option agreement from your employer and read it carefully to understand whether payroll taxes (Social Security and Medicare) will be withheld on that difference. If those taxes are not withheld, you should be prepared for the additional tax hit.
How important is diversification when it comes to NQOs?
Diversification of your portfolio is always important, and you want to make sure that your portfolio is not too concentrated in one company’s stock. Your investment goals and risk tolerance are two important factors to consider with how you diversify, and a CERTIFIED FINANCIAL PLANNER™ professional can help you find the mix of investments that supports your financial goals.
Kelly Luethje, CFP®, is Founder of Willow Planning Group, LLC. She provides financial education and guidance to help you live life on your terms. Kelly can usually be found on a mountain or by a lake working virtually with clients across the country across the country.