The image that a lot folks get in their heads when they hear the term 'employee stock options' is of employees at a tech start-up that hit it big in an initial public offering. We've all heard the tales of secretaries that were at the company from the beginning showing up to work driving a Porsche after their employer lavished stock options on them.
While some of these stories may be true, most workers that receive employee stock options don't become overnight millionaires. Even though that's the case, employee stock ownership plans (ESOPs) can be a great way to build a portfolio, especially since most companies award stock to their staff at prices below market value. factor that in, and ESOPs are almost like free money for your portfolio.
For the most part, employee stock options are a good thing, but there are some pitfalls that you should be aware of. First, it is unusual for a new employee to be able to redeem his options right away. Second, the options are considered income, so there are tax consequences to receiving them. And of course we cannot forget the fact that your company's stock price may decline before you can cash in your options.
All these factors are important to consider when receiving employee options, so let's take a look at how to effectively manage this part of your portfolio.
Put On Your Vest Before Cashing Out
More often than not, companies will require a vesting period before a worker can start cashing in on his options. This is to ensure staff loyalty and keep employees from redeeming their options and then leaving the company. For example, you may have just landed a new job and received 2,000 shares of stock as part of your compensation plan. Chances are you'll have to wait a few months or a year before redeeming any of those shares. This is known as a vesting period.
Additionally, it is also general practice that you won't be able to redeem all of your stock at one time. You might get to sell 500 shares after six months, another 500 after a year of service and so on. Remember that while these are referred to as options plans, they are not like buying a regular put or call with a one-month expiration. You've got to put your time in to get your reward.
Another interesting aspect concerning employee options compared to those traded on exchanges is that employees are very much at risk if their company is faltering. The employer does not have to make good on the options contract and the worker has limited recourse to force his boss to do so. Compare that to options traded on a traditional exchange where our winning trade must always be fulfilled and there are some rather stark differences between these two kinds of options.
Paying Uncle Sam
Of course the good folks at the Internal Revenue Service aren't just going to let you receive compensation without paying some taxes on it, but there are ways to avoid paying a larger than necessary tab on your employee options.
First, know what kind of options you're getting. An executive is likely to get what is known as an incentive stock option while a regular employee gets non-qualified stock options. For the latter, simply being granted the options isn't a taxable event, but upon exercise, be prepared to pay some tax. The IRS formula will subtract the price at which your options were granted from where the current market value of your employer to come up with your taxable income. For example, if you were granted options at $30 and the stock currently trades at $45, you would have taxable income of $1,500. ($45-$30 = $15 X 100 shares, or one contract, = $1,500).
So now you have your shares, but if you don't hold them for up to a year past when you exercised, you pay short-term capital gains. Holding the shares longer than a year results in long-term capital gains and those taxes are different.
Yes, the tax consequences of employee stock options can be confusing, and yes, it would be a good idea to consult a certified public accountant if you have employee options on your next tax return.
The InvestingAnswer: The bottom line is that employee stock options are great motivational tools to bolster worker loyalty and performance. You're likely to be a lot happier when your employer’s stock price is rising if you're directly reaping some reward for it. And you'll probably be a better worker because you want to help that stock price go up. Just remember that you've got to pay taxes on these little gifts and to get the necessary help so you're not saddled with a hefty bill from the IRS.