Stock Options Explained: Your Guide to Understanding Stock Options

Are you one of the 55% of Americans who own stocks? Or maybe you’ve started a new job and your employer offered you some stock options? Stocks offer a powerful investment tool but you need to know how they work.

Are you feeling a little confused? What are stock options, anyway?

You’ve come to the right place. Here, you’ll find stock options explained in an easy-to-understand way.

What Are Stocks?

Stocks and stock shares are the same. Before computers, shares of stocks were printed on paper and were “stock certificates.”

When most people use the word “stocks,” they’re referring to shares of a publicly-traded company. These company stocks are common stock. When you’re investing in publicly-traded stocks in the stock market, they’re usually common stock.

A stock share is a unit of stock, and it’s the smallest unit available.

The Microsoft Millionaires

Some people are wary about taking stock options in lieu of a higher salary or other monetary compensation for their employment. Don’t be hasty when it comes to turning down stock options.

Have you ever heard of the Microsoft Millionaires? Microsoft offered stock options to many of the company’s early employees.

After the company went public and the employees bought those stock options, the stock price soared. Many of those employees made millions.

There were even a couple of billionaires! We all know how wealthy Bill Gates is.

If you buy a company’s stock at a low price and sell when the price goes up, you make the difference when you sell. The hard part is knowing if a stock will go up or down, so it’s always a risk.

Stock Options

What are those stock options your employer offered you? The options give you the right to purchase shares of stock in the company at a later date. The price you’ll pay is often discounted from the market value.

The cost of a share of Microsoft soared after the company went public. The employees were able to buy Microsoft stock at a deep discount. They then turned around and sold the stock at the much higher market value, leaving them with a lot of extra cash!

There are two types of stock options:

  • Non-qualified stock options
  • Incentive stock options

The main difference between the two types of options is the way they’re taxed.

You can’t purchase your stock options until you’re “vested.” Vesting is the amount of time the employer makes you work for the company before you can buy the stock.

This is a way employers entice employees to stay with the company for a set amount of years.

There are different options trading levels and other ways of making money in the stock market. Here we’ll examine the different types of stock options you might get from an employer.

Non-Qualified Stock Options

If you’re offered stock options (NSOs, NQOs), they’re usually NSOs. NQO is another abbreviation for the same thing. These stocks are non-qualified because they don’t qualify for certain tax advantages.

Once you’ve vested, you can “exercise” your stock options. Exercising your options is purchasing the shares at the agreed-upon price.

Once you’ve exercised your stock options, you’ll pay income tax since the money is a form of wages. If you make money on the sale, you’ll also pay capital gains tax. That’s a tax on the money you make when you sell.

If you lose money on the sale, you can write that off on your taxes as a loss. Most people try not to sell unless they see a high potential for gain.

Incentive Stock Options

Incentive stock options (ISOs) receive better tax treatment. If you’ve got ISOs, you won’t pay regular income taxes. You will pay capital gains if you make money when you sell.

If you make more than $100,000 in a year when you sell an ISO, you’ll pay income tax too. The $100,000 limit stems from the fair market value when the stocks were given to you. The IRS takes into account your vesting schedule.

Is the fair market value of your stock $120,000? If the vesting schedule is four years, and you can only sell $30,000 per year, then you’ll fall under the $100,000 rule.

Like NSOs, ISOs have a holding period. You can’t exercise your options for at least two years from the time the company grants them.

Employee Stock Purchase Plans (ESPP)

Some companies offer ESPPs. This makes it easier for their employees to own stock in the company.

It’s not uncommon for the stocks to be offered at a discounted price. The company lets employees buy the stock through after-tax payroll deductions. The deductions are held by the company and then purchased on set purchase dates once or twice a year.

Restricted Stock Awards

These are awards and not options. The company gives you a predetermined amount of company stock after you’ve met certain restrictions.

What are those restrictions? That’s up to the company. Stock awards are usually tied with performance, time at the company, or some combination of the two.

Once you meet the conditions, the company awards you with the actual stocks or a cash equivalent. Expect to pay taxes on stock awards. You’ll pay income tax and capital gains tax.

Stock Options Explained

With these stock options explained, you’ve got a better idea of what to do with your stock options. Stock options are a nice way for employers to share the increasing value of a company with employees. Stock options aren’t a sure thing but they offer alternatives for employee compensation.

Some companies don’t increase in value, so your shares may not grow. If the company does gain value, stock options can be quite profitable. Many regular employees in the tech industry are now millionaires!

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