If stock options comprise a portion of your compensation, it’s imperative that you understand what you own and how to value it within your overall financial picture.

  • A stock option gives you the right to buy a certain number of the company’s shares at a fixed price for a certain number of years.
  • There are two principal types of stock options— “incentive options” and “non-qualified options”— each with unique rules and tax consequences.
  • If options are valued correctly and exercised in ways that minimize the tax consequences, they can be a valuable portion of your overall wealth.

If you are a corporate executive or plan to be one someday, a substantial portion of your compensation may be provided in stock options. Are stock options the same as good old cash? Not exactly. Traditionally, stock options have been used as a way for companies to reward top management and link their interests with those of the company and other shareholders.

Basically, a stock option gives you the right to buy a certain number of the company’s shares at a fixed price for a certain number of years. The price at which the option is provided is called the “grant price,” and it is usually the market price at the time the options are granted. Option rights are usually vested, meaning only a certain percentage of the options can be exercised at different points in time. There is usually a time limit on the exercise of the shares, typically 10 years from the date the options were granted.

Types of stock options

There are two principal types of stock options— “incentive options” and “non-qualified options”— each with unique rules and tax consequences. With incentive options, you are not required to pay taxes on the “spread” between the grant price and the exercise price until the shares are sold. Capital gains taxes would then be due. With non-qualified stock options, you must pay taxes on the spread each year, just as if it were income or wages.

Do you actually own the options? Yes and no. Until you exercise your stock options, they remain on the company’s books as an asset of the company and a benefit to you. Only when you own the options are they considered an asset in your portfolio. This is why it is tricky to determine the actual value of the stock options in your portfolio.

What is an option status statement?

An option status statement should be used as a supplement to your personal financial statement to help you accurately determine your total wealth. An option status statement will typically include the following information about your stock options:

  • the date the options were awarded
  • the type of options – incentive or non-qualified
  • the number of shares granted
  • the price per share
  • the number of shares exercised
  • the vested and unvested number of shares
  • the options cancelled
  • the total number of shares outstanding
  • the exercisable number of shares

In this way, you can easily see which options you own (that is, the number of options you have exercised) as an asset, and which options remain as assets of the company and potential future assets of yours. Options should be exercised on a regular basis to manage the asset consistently and properly.

Exercising your options

The usual timeframe within which options should be exercised is 10 years. The exercise can be a cashless transaction, where the difference between the price of the options and the current market value of the stock is paid in cash. Non-qualified options can be exercised for cash or held in certificate or book-entry form. However, the spread between the option price and the market value is subject to ordinary income tax. Incentive stock options may also be exercised as a cashless transaction, but this would be subject to income tax. Keep in mind that capital gains taxes also apply when you exercise stock options, but you can hold this tax to a minimum if you exercise your options by purchasing and holding them for one year.

As you can see, understanding stock options and determining their value to you can be somewhat complicated. If stock options comprise a portion of your compensation, it is imperative that you understand what you own and how to value it within your overall financial picture. If options are valued correctly and exercised in ways that minimize the tax consequences, they can be a valuable portion of your overall wealth.

This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, investment, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.