Non qualified stock options
Non qualified stock options (NQ or NQSO) are one of three types of stock options commonly received by tech employees in San Francisco. Incentive stock options (ISO) and restricted stock units (RSU) are the others.
None of the three are taxable when granted, but that’s where the similarities end.
There is no decision to be made with restricted stock units. They vest. You get taxed.
Incentive stock options require a decision. You decide when to exercise. But, the exercise of your incentive stock options may not be taxable.
Non qualified stock options are somewhere in between ISO and RSU. You decide when to exercise, and your decision will be a taxable event.
How Non Qualified Stock Options Work
Non qualified stock options vest over a period of time. After vesting, you can exercise the non qualified stock options any time up to the expiration date of the option (Generally 10 years). At the time of exercise, the difference between the market value of the stock and your strike price (exercise price) is taxable income and is included on your form W2.
Taxable Income on Exercise of NQSO = Shares Exercised (Fair Market Value – Exercise Price)
This taxable income is incurred whether you hold the stock or sell it immediately and is taxed at ordinary income tax rates. Capital gain rates do not apply to this income. This is why one common strategy with nonqualified stock options is to do a same day sale.
Let’s say that three years ago you started working for a start-up in San Francisco that has since went through an initial public offering (IPO). You were granted incentive stock options when you started working there, nonqualified stock options after that, and now restricted stock units.
Your 5,000 shares of NQSO’s are fully vested with a strike price of $5.00, and the stock is trading at $25.00. Your taxable income on the day you exercise would be:
5,000 ($25.00 – $5.00) = $100,000 Taxable Income
$100,000 x Marginal Tax Rate = Tax Owed on Exercise
Paying the top tax rate of 39.6%, your federal tax owed on the exercise of 5,000 nonqualified stock options will be $39,600.
$100,000 x .396 = $39,600
If you exercise and sale on the same day, your tax bill related to your nonqualified stock options will be fixed and easy to determine using the formula.
On the other hand, exercising and holding the shares introduces the potential for a capital gain or loss. Your cost basis used to determine your capital gain will be your cost to exercise plus the income you paid taxes on at exercise.
Cost Basis of NQSO Held = Cost to Exercise + Income Recognized at Exercise
(5,000 x $5.00) + $100,000 = $125,000
Holding instead of doing a same day sale introduces additional factors to consider in your decision making. When will you sell? What might your future capital gains tax bill be? What do you do if the stock loses value?
You will also have to check that your cost basis is properly reported to the IRS, when you sell. Beware of getting double taxed on shares of NQSO that are held and sold at a later date.
Things You Should Know Before Exercising
Before you exercise your nonqualified stock options, you want to make sure you have all the information you need to make a good decision. Stock options involve a number of factors, everything from tax to investment to financial planning.
Taxes are especially troubling. You exercise now, and owe taxes immediately. Your employer will usually withhold federal and state income taxes on the income you recognize at exercise. But, there’s no guarantee that the withholding will be enough.
You may owe more when you file your taxes next year. You want to know what that tax bill is ahead of time. It pays to be prepared. Here is what you need to know:
What is your top tax rate?
Check your last tax return. There will often be a tax summary included by your return preparer in the first few pages. You may find your marginal tax bracket expressed here as a percentage.If it’s not there, check form 1040 of your return. You will find your taxable income around line 43. This number determines your top tax rate. Perform an internet search for “IRS Tax Brackets” and compare your taxable income to this year’s tax brackets.
This will likely be your top tax rate for this year if your salary and bonus will be similar to last. The difference between your strike price and the fair market value of your shares will likely be taxed at this rate.
Did you pay the alternative minimum tax (AMT) last year?
Go back to form 1040 of last year’s tax return. Around line 45, you will see Alternative Minimum Tax. You paid the AMT if there is a number entered on this line. You will probably pay the AMT again if you expect this year’s income to be like last year’s.The exercise of your nonqualified stock options may be taxed at a 28% rate if you expect to pay AMT.
What is your strike price?
Your strike price is also referred to as your exercise price. This is the price you pay to exercise your non qualified stock options. You can usually find it by logging into your stock options account. It may also be listed on your original award document.Knowing the strike price helps you start to determine the cost of exercising. A cashless exercise, where shares are sold to cover the cost of exercising, may be an option. But, if you plan to hold the shares, you will need to have the cash available to cover your strike price.
You will also have to have the cash available to cover the taxes. Doing something other than a same-day sale becomes a costly affair with both the cost to exercise and taxes owed.
What is the fair market value of the shares?
This should be easy to determine and is probably available by logging into your stock options account. You can also just search the stock’s ticker symbol (three to five letter code that the stock trades by) on Google Finance or Morningstar.The strike price determines the cost. Knowing both the strike price and fair market value helps you determine how much income you will owe taxes on when you exercise.
Do you have to plan around trading windows?
You may have to plan around blackout periods or open trading windows if you plan to exercise and sell the non qualified stock options. The open trading windows usually follow your company’s quarterly earnings call. Check with your employee benefits specialist or human resources department to see if this applies to you.
Tax Savings Strategies for Nonqualified Stock Options
Your taxable income determines your tax rate, which can be as high as 39.6%. Progressive state income tax rates will also apply. Working in San Francisco, your state tax rate can reach 12.3%.
The income from exercising your NQSO’s is taxed at these rates. The first way to save is to exercise when you are subject to lower tax rates. Very often you can control the timing of income and deductions to create an opportunity to exercise when your marginal rate is most favorable. For example, you may be contemplating selling property or other securities, which result in large capital gains. You can control the timing of these transactions. Instead of selling an asset in December, you may hold off until January of the following year. You can also defer or accelerate the timing of deductions for items such as state income tax, property tax, or charitable contributions.
Another tax savings strategy is to exercise your NQSO’s during a year when you expect to incur alternative minimum tax (AMT). Some tech employees, with lower income, can avoid the alternative minimum tax altogether. You may find yourself in a position where your salary and bonus alone make paying AMT unavoidable. Often you will be able to pay tax at the 28% marginal rate under this strategy. The tax savings at 28% is significant compared to the higher 35% or 39.6% rates you may pay with the ordinary income tax.
One hundred thousand dollars from the example above taxed at a 28% rate will result in a tax bill of $28,000 a savings of $11,600 compared to paying the top rate of 39.6%.
Bonus Tip – Combining NQSO and ISO Exercises in the Same Year
If you have been granted both incentive stock options and non qualified stock options, it may be favorable to exercise NQSO’s and ISO’s in the same calendar year. When you exercise the NQSO’s, you generate ordinary income for regular tax purposes. When you exercise and hold the ISO’s, you do not generate any taxable income for regular tax purposes but you create income for purposes of calculating AMT.
By exercising and holding the incentive stock options, you can generate AMT and create the scenario in which the exercise of NQSO’s can be taxed at about 28% rather than the higher marginal rates of 35% or 39.6%.
There is often a big tax benefit by doing a same day sale of nonqualified stock options in the same year you exercise and hold incentive stock options. This also provides an opportunity to take some cash off the table by doing a same day sale of NQSO’s while preserving the capital gain treatment if you hold the ISO’s for more than one year. To the extent you incur AMT on the exercise of ISO’s, you generate a minimum tax credit which may be usable in future years.
Crunching the Numbers
Nonqualified stock options are one of the three main types of stock options we see on a regular basis as we build financial plans for tech industry professionals in San Francisco. Your stock options represent a huge part of your compensation and wealth building potential.
Knowing when to exercise, when to sell, and how to use the proceeds from your nonqualified stock options can put more money in your pocket and make the check you have to write to the tax man a lot smaller.