Non Qualified Stock Options (NSOs) are a wonderful way to build wealth, but a lot of times people make blunders. Every dollar counts! Here are some pointers on how to avoid NSO mistakes.
NSOs are like ripe fruit. One of my favorite things to do during the summer is to enjoy fresh fruit – especially blueberries. As a kid, our family would go on many adventures for wild blueberries. The results were great – muffins, pies, and nice additions to the morning yogurt.
But I’ll let you in on a little secret. During these excursions, I remember being quite hungry and more berries would end up in my mouth than in the jar.
The same goes for NSOs. You use the NSOs when they are “ripe” and you “eat” them right away.
NSO Mistakes Explained
Today we are going to talk about the common NSO mistakes that employees make. Alternatively, we will look at a plan to use them well.
First, some people exercise NSOs right away because they want to own the shares. It’s great to own shares in your company. However, when you exercise the options you incur risk by taking on ownership. And you must pay tax on the option exercise. Remember that NSOs are taxed as compensation – ordinary income taxes and FICA taxes.
Another common mistake is exercising NSOs when the stock price is down. When there is a drop in the stock price, sometimes employees confusedly exercise NSOs so they can buy the stock at a lower price. But remember, you buy the stock at the NSO option price, not at the current market price.
A Great Plan for You
You have 10,000 NSOs and you will sell all the shares at the end of five years. For our illustration, we assume that the stock price starts at $100 per share and it magically increases by 25% each year.
Additionally, the exercise price for the options is $50.
So do you exercise the options when you receive them or wait until the end of the five year period?
| Exercise at Beginning | Exercise at End | |
|---|---|---|
| Options Granted | 10,000 | 10,000 |
| Share Held at End of 5 Years | 3,150 | 10,000 |
| Share Price at End of 5 Years | $305.18 | $305.18 |
| Value at Sale | $961,304 | $2,551,758 |
| Less Taxes | ($192,261) | ($944,150) |
| After Tax Value | $769,043 | $1,607,607 |
When you wait until the end of 5 years, you have double the money! A thorough explanation follows so you don’t make any NSO mistakes.
In Depth Explanation
Let’s take a look at both scenarios.
First, let’s look at the share amount. When you exercise in the beginning, you lose 5,000 shares to exercise the options ($50 per share exercise price). Then you give up more shares for the ordinary income tax and FICA tax on the remaining 5,000 shares. When it’s all said and done, you will have 3,150 shares left.
On the other hand, when you wait until the end, you will have all 10,000 shares growing over the 5 year period. When you exercise the options, you have to pay $500,000 (accounted for in the Value at Sale) for the shares and pay short term capital gains taxes. However, you cannot beat the 10,000 shares compounding over time.
Next are the taxes. If you exercise right away and hold the shares for 5 years you will pay long term capital gains tax. When you wait until the end and sell you will have short term capital gains – a much higher rate. But you can see that it’s worth it to wait until the end so your shares keep gaining value.
When the fruit is ripe, you pick it and eat it right away.
Avoid NSO mistakes. Don’t exercise until you are ready to liquidate and make it your default setting.
Would you like to chat about NSOs, blueberry muffin recipes, or anything else?