How Do Stock Options Work?
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by: MattCBA
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A stock-option basically gives an employee the right, but not the obligation or requirement, to purchase a certain number of shares of company stock at a set price at any time in the future before the option expires. Usually a stock option grant is good for 10 years, so if your company gives you an option to buy 1000 shares of company stock today and it’s trading at $50, you’ve got 10 years to decide whether or not you want to buy those 1000 shares. Whenever you choose to buy down the line, your cost is $50 — even if the company stock is trading at $100 or $150. That’s the value of a stock-option.
The two most common types are non-qualified stock options (NQSO) and incentive stock options (ISO). The most common is the non-qualified stock option – what that means is when you decide to buy the stock, you are going to be taxed at ordinary income tax rates on the paper profit, whether you buy the stock and hold it or immediately sell it.
From a purely tax planning point of view, it generally makes sense to simply buy and immediately sell the non-qualified stock option. Especially since most publicly traded companies have a mechanism that creates a cashless stock option exercise, so you don’t even have to come up with the money to buy the stock if you’re going to immediately turn around and sell it.
(ISO) incentive stock options are even better – because incentive stock options can qualify for long term capital gain tax treatment.
Say you’ve got a grant for a 1000 shares of stock at $50. It’s trading now at $150. You decide to exercise your option. Well, if you exercise and sell, that $100,000 profit is still treated as ordinary income.
However, with an incentive stock option you have the option or the choice to hold the stock for 12 months. If you hold it for 12 months and a day and then sell, that stock receives long-term capital gain tax treatment. So that $100,000 of profit is now taxed at long-term capital gain rates instead of ordinary income tax rates. A potential tax savings of $20,000. Assuming of course the stock price doesn’t go down. But that’s a topic for another time.
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About the Author
About Brian L. Fricke, CFP®: Brian Fricke is the Author of “Worry Free Retirement, Do What You Want, When you Want, Where You Want”. For the last 6 years in a row Brian and his company – Financial Management Concepts – have been named one of America’s Top Wealth Managers. Orlando Business Journal has named his firm one of the top financial planning companies in Central Florida. Financial Advisor magazine – an industry trade journal- has recognized him as one of the leading financial planning firms in America. If you’ve been in Central Florida over 10 years, you may have heard him on the radio. He used to host his own show on WDBO radio. He’s also served on the City of Winter Springs Board of Trustees Pension Fund. Brian is a Certified Financial Planner. His firm – Financial Management Concepts – is a Fee Only Financial Planning firm. They currently manage over $98 million of investment assets for a select community of clients. Brian and his team have worked with retirees and pre-retirees from companies like AT&T, Sprint, Harris, Lockheed Martin and Siemens/Westinghouse. For more information, please visit http://www.BrianFricke.com
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