When your employer awards you non-qualified stock options, you may be able to use them to buy shares of company stock at a discount off the market price. Companies award stock options to retain, reward and motivate employees. That’s great, but you will probably have a waiting period before cashing in on employee stock options.
Non-Qualified Options Basics
When your company gives you non-qualified stock options, what you get is the right to buy a specified number of shares of company stock at a guaranteed “exercise” price. You are not obligated to use the options, but if you do it’s called exercising them. The term “non-qualified” means the Internal Revenue Service considers the difference between the exercise price and a higher market price at the time of exercise to be taxable compensation like your salary. The amount of your profit is called the bargain element and appears on your Form W-2.
Vesting and Exercise
Typically, your employer will require that you wait for a specified period of time after you are awarded non-qualified stock options before exercising them. This waiting period is called a vesting period. Once the vesting period is completed, you may not want to exercise the options immediately. If the market value of the stock is less than the exercise price, using the options is worse than useless because the shares would be cheaper if you bought them at the market price. In this situation, you would hold onto the options and hope the price goes up before the options expire.
Vesting schedules are stated in the terms of non-qualified stock options awards. Usually only a portion of the options are vested at one time. For example, 20 percent of the options might be vested after one year and another 20 percent each year until 100 percent are vested. If you leave the job before some of the options are vested, you lose them. You’d still be able to use vested options not exercised when you left your job.
Incentive Stock Options
Employers may offer another kind of stock options called incentive options. Under IRS rules, the bargain element is considered a capital gain -- not compensation -- and taxed at a maximum rate of 15 percent as of 2013. To get the tax break, you must wait at least one year to exercise incentive options. The company may require a longer vesting period. You then must hold the shares for at least one additional year before selling them. Under IRS rules, no more than $100,000 worth of incentive options may vest per year. There's no vesting limit for non-qualified options.