7 important facts you need to know about incentive stock options
Last updated: February 6, 2023
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Jennifer Young
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7 important facts you need to know about incentive stock options
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This article was written for informational purposes only and should not be construed as legal, financial, tax, or any other kind of advice.

One crucial detail you should consider when looking at job opportunities is what benefits you’ll get if you’re hired.

But not all job benefits work the same way. While some are pretty straightforward to understand, like paid time off or 401(k) programs, some are more complicated.

One of the benefits you might have encountered is an incentive stock option or ISO.

So, what are they, and what does it mean if your employer provides them to you? Let’s explore the basics of incentive stock options and answer some important questions about them.

What are incentive stock options?

Incentive stock options (ISOs) are a type of job benefit offered by several employers, including early-stage startups.

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You may also hear them described as statutory stock options or qualified stock options.

When you have this benefit, it gives you the right to purchase shares, or stocks, from the company you work for. But instead of purchasing them at market value, you get them at a reduced price.

Companies offer this type of benefit to their employees to incentivize them to remain with them long-term. Employees who buy into incentive stock options have an opportunity to contribute to the company’s growth and development. As the price of the stock rises, so does the value of this benefit.

How do incentive stock options work?

When you get (granted) employee stock options, you can purchase (option to buy) them at a price your employer sets. This is called the strike price. The strike price will usually be close to the price at which the shares are valued at the time your employer sets it.

Each option is awarded on a date called the grant date. These dates might take time to vest - meaning that grants may be awarded over a period of time, typically years. The grant date is the day you are eligible, or have the option to buy the shares. Please note: on the grant date, you do not own shares, you own the right to purchase the shares at the strike price.

You can exercise your stock options on your exercise date, which will vary by company. Exercising means you’re buying the stock at the strike price. You’re not buying at the current market value of the stock.

Let’s explore an example to see what this could look like. If you are granted 100 shares in options at a strike price of $5, that means you’ll have the right to buy 100 shares for $500.

No one can predict market value, so your options are not guaranteed to return a profit, but these benefits are awarded with the hope that at a future point in time, the market value of those shares will be greater than the cost to purchase the shares.

Using the hypothetical example above, if the market price of the shares is now $7 and you are allowed to exercise your options, you can buy (pay) 100 shares for $500, and sell (receive) the 100 shares for $700 ($7 market price * 100 shares) for a $200 profit.

Of course if the market value is not greater than the strike price, you can hold onto your share options until the market value is more favorable or until they expire.

Typically, companies will set a vesting schedule that determine when your option to buy is effective, and when you can exercise your options. A vesting schedule dictates a period of time after which you are allowed to exercise your stock options. Vesting this benefit over time encourages employees to stick with the company long-term.

Some companies will require you to wait three or four years before you can exercise any portion of your stock.

But other companies will incorporate a graded vesting schedule instead.

Let’s break down what this means.

On a typical graded vesting schedule, after an initial two years, you gain access to 1/5 of your options each year. So, after six years with the company, you own all of your options.

If you decide to leave the company two years after being granted your ISOs, you’ll own 1/5 or 20% of your options. Bear in mind that not all companies follow the same vesting schedule, so you’ll want to discuss these details with the hiring manager or HR specialist.

7 frequently asked questions about ISOs

So, should you get incentive stock options? Let’s break down some answers to commonly asked questions about ISOs.

This article was written for informational purposes only and should not be construed as legal, financial, tax, or any other kind of advice.

1. How are incentive stock options taxed?

If you exercise your ISO, the shares can be taxed more favorably than other types of stocks. But you need to meet certain criteria to get this tax benefit.

For instance, you’ll need to hold your shares for more than one year after the date of the exercise (buying shares) and more than two years after the time of the grant. You’re allowed to sell them back sooner, but you won’t get as much of a favorable tax treatment if you do.

Under those conditions, your profits may be taxed at a capital gains rate instead of earned taxable income. Capital gain tax rates range from 0%–20%, while income tax rates vary from 10%–37%. The specific number depends on your income.

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2. When do incentive stock options expire?

Incentive stock options don’t last forever. In most cases, they’ll expire ten years after the grant date, but the expiration date of YOUR ISOs should be stated in the legal document provided by the company. Once the option to buy expires, you will no longer be able to purchase your company shares at the strike price established on the contract.

However, ISOs might expire before the expiration date in certain instances - like if you decide to leave your company before the expiration date or if your contract states different terms.

3. What is the difference between incentive stock options and non-qualified stock options?

Non-qualified stock options (NSOs) are a more common type of stock option than ISOs. They’re also simpler to understand.

Like ISOs, NSOs give you the right to buy a specific number of shares at a preset price. You’ll also have an expiration date to exercise them. But NSOs don’t give you all the tax break benefits you get from ISOs.

Some companies offer NSOs because they can grant them to more than just employees. People who work with the company in other ways, like contractors, consultants, advisors, and directors, can get NSOs.

On the other hand, a company can only grant ISOs to its employees. This means that if you’re only contracting for a company, you won’t be able to get ISOs from them.

For example, if you get a temporary gig to get some quick cash, you can’t get ISOs as a benefit.

4. What is the difference between incentive stock options and restricted stock units?

Your employer may also grant you a different type of stock, called restricted stock units (RSUs), instead of incentive stock options.

What’s the difference?

RSUs are a lot simpler to understand than ISOs. They don’t involve the “option to buy”. This means there’s a direct grant of shares or cash.

As an employee, you can “cash out” the value of your RSUs either in stock or in cash. However, unlike unrestricted shares, an RSU does not carry the right to earn dividends. Dividends are a distribution of additional shares or cash to certain shareholders in a company.

Whereas shares purchased through an ISOs, typically have rights to dividends issued during your ownership of those shares.

5. When is the best time to exercise incentive stock options?

There’s no perfect time to exercise your incentive stock options. It all depends on the amount of risk you’re willing to take and your individual tax situation.

For example, if your financial needs and goals are short term, and exercising your options is possible, you may consider exercising your options as soon as they’ve vested.

However, if your goal is to minimize taxes, you may need to wait two years after the grant date or one year after your date of exercise before you sell your shares of stock. You may need to seek advice from a tax advisor or financial expert to figure the best options for your situation.

It’s important to understand that waiting for share value to increase is not a guarantee of increased profit. Company share values change for a variety of reasons and are never guaranteed.

Another option is to average out your sales. After you exercise your stock options, you can sell off a portion of those stocks (your holdings) over time.

Because you’re not selling everything all in one go, you may mitigate the risk while also opening yourself up to the possibility of making more profit than if you sold everything right away. You’re also not opening yourself up to as much risk as you would if you held all of your shares for an extended period.

Some may decide, after exercising ISOs to hold onto shares for long-term capital ‘gains’. If the company keeps growing over time and share values go up, you’ll make money from both the increased market value on the shares and potentially dividends issued on the stock.

6. What happens to your ISOs when you leave your employer?

If you decide to make a career change and leave your employer before you exercise your shares, you’ll usually have some time to buy your shares — assuming you hung around long enough to hit the vesting date.

Not all employers are the same, so make sure you look into it before deciding (it will be on your ISO contract).

In many cases, you’ll have 90 days to exercise your options after you decide to leave your employer. However, some employers may give you more (or less) time.

You’ll also only be able to exercise your vested ISOs. Here’s what this can look like depending on a variety of scenarios:

  1. Your employer has a vesting schedule of three years. You decide to leave after two years. This means you cannot exercise any of your ISOs.

  2. Your employer has a graded vesting schedule over a period of six years, where you earn ⅕ each year, starting at the end of the second year. You decide to leave after three years. This means you have 90 days to exercise 2/5, or 40%, of your stocks. You lose the remaining (unvested) options.

  3. Your employer has a vesting schedule of three years. You decide to leave after four years. You retain 100% of your stock options, but you have a limited amount of time to exercise them if you haven’t already.

7. What can you do if you don’t have the funds to exercise your ISOs?

Let’s say you’ve been granted ISOs and you want to exercise them, but you don’t have the cash on hand to purchase the stock. You can ask your employer if they have a “cashless exercise” option available.

In a cashless exercise, you exercise your shares and sell them right away. A brokerage firm will usually facilitate these two transactions.

This firm will exercise the stock for you, then sell it back on the open market on the same day. You then get the profit back, minus the cost of commissions and fees, withholding tax, and any other associated reductions.

Keep in mind that you’ll very likely have to pay income tax on your profits, even when you do a cashless exercise.

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Make the most of your employee incentive stock options

Now you have what you need to know about incentive stock options to make an informed decision. If your current employer offers ISOs, you’ll know how to make the most of this employee benefit.

For more information on employee benefits and how to maximize your job earnings, visit the The Resource Center for Workers on job benefits, pay and perks.

This article was written for informational purposes only and should not be construed as legal, financial, tax, or any other kind of advice.

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Ford Simpson
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Jack of all trades,.master of none

I would advise anyone to consult with a financial advisor,there is risk in not fully understanding.Ford

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