Non-Qualified Stock Options (NSO): The Basics
Last Updated on May 11, 2021
Non-qualified stock options (NSO’s) are a specific type of employee stock option. What are employee stock options? In a nutshell, employers can give their employees the right to buy a certain number of company shares at a designated price within a specified time period. Hence the name, stock option – employees have the option to buy their company’s shares within certain parameters.
This fixed price, also known as the strike price, is typically whatever the market value is at the time an employee is granted the non-qualified stock option. This is why NSO’s are seen as a benefit. If all goes according to plan and the company’s share price goes up, then employees with non-qualified stock options have the ability to buy those shares at a discount.
Exercising non-qualified stock options
Options have a deadline with which employees must decide whether or not they will ‘exercise’ their options. Exercising means to take action, and there are a few different actions you can take.
Action 1
If you choose not to exercise (i.e. do nothing), the options will expire. That means you’ll lose the ability to purchase said shares at the preset price that was initially granted to you.
Action 2
If you choose to purchase and hold the shares, you will become a shareholder of the company.
Action 3
A third way to exercise your options is by purchasing and then subsequently selling your shares – either immediately or further down the road.
Note that for both action 2 and 3, the act of purchasing and selling shares can result in tax implications which we’ll cover shortly.
Why employers offer NSO’s
Non-qualified stock options are one type of stock option that employers utilize to attract and retain talent. They’re considered a form of additional compensation for the employee outside of a traditional salary or benefits. While NSO’s tend to be most common, employers can also offer other types including incentive stock options and restricted stock units.
How do NSO’s attract employee talent?
If you believe in a company and their potential for success, then you likely also believe their stock price will rise. For NSO holding employees, it’s an opportunity to buy shares of a great company at a discounted price. When it comes time to exercise, that additional value can be cashed in as extra compensation or retained as the stock price (hopefully) continues to rise.
How do NSO’s retain employee talent?
Non-qualified stock options help to retain employee talent because they have a strict timeline with which options can be exercised. If an NSO holding employee leaves their job before that window of time opens, they forfeit their options. Additionally, NSO’s reinforce the employee mentality that when you do well, your company does well, the stock price rises, and you benefit as a shareholder.
How are NSO’s taxed?
Non-qualified stock options are taxed two times: when you exercise your options and when you sell your shares (unless you sell them at a loss).
When you exercise your options by purchasing shares, employers typically withhold ordinary income tax on the difference between the market price and the NSO designated price you actually paid for your shares. The difference between what you paid (the strike price) and what the market value was at the point you exercised your options is often referred to as the spread.
Some employees will elect to immediately sell off a number of their shares to cover the cost of those taxes. That tactic is referred to as a cashless exercise since it allows you to exercise your options without shelling out additional cash to cover your taxes.
Employees will also be taxed when they opt to sell their shares. Depending on how long you chose to hold your shares before selling them will dictate how they are taxed.
A quick tax lesson
The US utilizes a progressive tax system. Based on your income level and filing status, your ordinary income tax rate will fall in the range of 10%-37%. In many cases, the long term capital gains tax rate is lower, which falls between 0%-20%, depending on your total taxable income.
To further complicate things, there are actually two capital gains tax rates – short term and long term. Short term capital gains tax applies to capital assets which are held for one year or less. The gains on their sale are taxed as ordinary income.
Long term capital gains tax is applied when capital assets are held for more than one year. As previously mentioned, the long term capital gains tax tends to be more favorable depending on your income tax bracket.
When should you exercise non-qualified stock options?
First things first, make yourself aware of the window of time available for you to exercise your options. Some companies utilize a vesting period which means you’re unable to exercise your options until a certain point in time. Other companies allow you to exercise your options as soon as they’re granted to you. Keep in mind that your ability to exercise your options will expire at a specified time.
Once you are aware of the timeline with which you can exercise your stock options, you can begin to strategize your plan of action. When the time comes, you can choose not to purchase the shares, purchase and hold the shares, purchase and sell some of the shares, or purchase and sell all of the shares.
In order to determine what makes the most sense, you’ll want to evaluate how you expect the company to perform in the short and long term. You’ll also want to think about your current tax bracket and decide if it’s likely that your tax bracket may change in the future. Lastly, be sure to consider the impact the shares could have on your investment portfolio’s risk and level of diversification.
Example 1
If you believe your company may be stagnating and do not foresee the stock price rising in the near or distant future, it may be beneficial for you to exercise your options as soon as you are able to and immediately sell them. With this method you are essentially treating your options as additional compensation and you can choose to reinvest, save, or spend that money how you see fit.
Example 2
If you believe your company is charging towards success with a high likelihood of sustained innovation and profitability in the future, it may be beneficial for you to exercise your options as soon as you’re able to and plan to hold those shares for as long as makes sense. By exercising them as soon as possible, you minimize your first round of taxation, but should expect that your second capital gains tax bill could be quite high.
Example 3
If your company is on the decline and you do not foresee any potential stock price rebounds, it may be beneficial for you to not exercise your options at all. If the strike price is greater than the market value, those shares would inherently have no value to you as you’d be purchasing them at a loss.
Non-qualified vs. qualified stock options
Another, less common stock option employers may provide is called a qualified stock option. The primary difference between qualified and non-qualified stock options is taxation. Qualified stock options, also known as incentive stock options, come with tax advantages as long as the owners are willing to abide by certain timeline and activity restrictions.
First and foremost, employees do not have to pay any tax at the point the qualified stock options are exercised. Secondly, if an employee with qualified stock options holds their shares for one year after the purchase and two years after they were granted, any gains will be taxed at the long term capital gains rate, as opposed to the ordinary income tax rate.
Finally, qualified stock options are typically more restrictive in terms of which employees they may be granted to.
The bottom line
Non-qualified stock options can be a great benefit. But be sure to pay attention to:
- Your options timeline
- The associated tax implications
- Your company’s overall outlook
By paying attention to those three things, you can make the most educated financial decision for you and your portfolio.
