Companies frequently provide their employees with stock options as a means of promoting a longer sense of loyalty and ownership. Non-qualified stock options (NSOs) and incentive stock options (ISOs) are the two most popular kinds of stock options that encourage employee investment opportunities.

In this article, we go over the potential tax ramifications as well as the pros and cons of both ISOs and NSOs.  

Incentive Stock Options

With the possibility of larger gains if the stock price moves above the striking price, ISOs reward employees with the opportunity to buy company stock at a reduced price. Below is a summary of the main features:

• Tax implications: ISOs can provide significant tax value. There is no up-front tax withholding when you buy the shares and exercise the option. Taxes are not due until after you sell the shares. That means any capital gains on the sale are taxed at the lower capital gains rate (usually lower than ordinary income tax rates) as long as you keep the stock for at least a year after exercising the option and two years after it was granted.
• Pros: The key feature of ISOs is the possibility of tax mitigation. A sense of ownership in the company’s achievements can also provide a boost to employees, since it can encourage them to match their financial objectives with the expansion of the business.
• Cons: There are certain restrictions to think about here. It usually takes two years after grant and one year following exercise for you to be able to sell ISOs and get the favorable capital gains tax treatment. Additionally, there’s always a chance that the stock price won’t climb above the strike price, which could mean that if you decide to sell the shares at a lower price, you end up with no profit at all.

Non-Qualified Stock Options

Compared to ISOs, NSOs are a more straightforward type of stock option. Here’s what you should know:

• Tax implications: NSOs do not provide the same tax mitigation as ISOs. The difference between the strike price and the stock’s fair market value on the exercise date is treated as regular income and is subject to ordinary income taxes.  
• Pros: NSOs can still be a worthwhile kind of compensation, particularly if you think there could be a big increase in the stock price. After you exercise the option, there are usually no holding time requirements before selling the shares. This gives your investing strategy greater flexibility.
• Cons: The downside of NSOs is that when you exercise the option, you’ll be on the hook for ordinary income tax. This can drastically cut into your prospective profits, especially if by the time you exercise the stock price hasn’t increased much. In addition, NSOs don’t share ISOs’ sense of ownership or commitment to the company’s accomplishments.

How to Choose Between ISO and NSOs

The smartest choice for you depends on your risk tolerance, financial goals, and individual circumstances. Here are some factors to consider: 

• Tax implications: Due to the possibility of cheaper capital gains taxes, ISOs are typically preferred if tax consequences are a top concern. But you have to account for the restrictions of the holding time.
• Investment outlook: Because of the possibility of tax mitigation, ISOs are typically a better choice if you intend to own the stock for a long period of time—at least a few years. On the other hand, because NSOs have no holding period limits and can be sold at any time, they’re generally a better option for investors with shorter investment horizons.
• Company growth potential: Both ISOs and NSOs can be wise choices if you believe in the company’s future and think the stock price can increase considerably. However, with ISOs, you’ll potentially enjoy lower taxes on your gains. 
• Risk tolerance: When you exercise the option, NSOs have a larger initial tax burden. For risk-averse investors, this could be a major drawback.

Picking the right employee stock option can get complicated. Our team at ATS Wealth Circle is here to guide you toward a choice that aligns with your specific financial situation.

If you or someone you know would like to know more about retirement and investment strategies, call (408) 333-9998 to schedule a meeting today.

This material is being provided for information purposes only and is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation.  The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Future investment performance cannot be guaranteed, investment yields will fluctuate with market conditions. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Prior to making an investment decision, please consult with your financial advisor about your individual situation. Neither Raymond James Financial Services nor any Raymond James Financial Advisor renders advice on tax or legal issues, these matters should be discussed with the appropriate professional.