Stocks | November 22, 2019

Understanding the Risks of Employee Stock Options

Many clients I work with appreciate having equity as part of their compensation packages. In fact, a recent Schwab survey found that more than a third of employees say it’s a big part of why they took their jobs.1

When managed effectively, stock options can be a great tool for building long-term wealth. However, there’s often confusion regarding how stock options work and whether it makes sense to keep or sell the underlying shares.

Here are answers to the three most common questions I get about employee stock options.

1. Should I keep or sell my shares?

First, determine whether your employer’s stock complements your investment strategy. As with any prospective stock, you should research the fundamentals to understand its long-term potential and risk characteristics.

If you exercise your options and keep the stock, presumably it’s because you believe it will rise; needless to say, that’s not always the case. To help ensure you’re not overexposed, you may want to limit your employer’s stock to no more than 20% of your overall portfolio.

There’s also another kind of overexposure to consider: If your employer gets into financial trouble, you could end up losing money on the stock and losing your job. If that level of exposure makes you uncomfortable, it may make more sense to sell your eligible shares.

That said, there are circumstances under which you may need to hold on to an inordinately large amount of your employer’s stock. Some companies impose holding requirements, for example, or you may have trading windows that limit your ability to sell.

Conversely, some employees like having larger allocations to their employer’s stock because they like having skin in the game and are confident of their company’s prospects. Whatever your reason, make sure to consider the risk to your overall investment strategy.

2. What are my stock options worth—and how do I capture their value?

Stock options allow you to buy stock at a specific price during a certain time period. The value lies in the spread—the difference between the exercise price and the market price.

For example, say you have 2,000 options with an exercise price of $40 and a market price of $50. Your potential profit is $20,000 (the $10 spread times 2,000 options)—and you commonly have three choices when it comes to realizing their value:

A) Exercise and hold: In the example above, you’d buy the stock and hold it, spending $80,000 up front for $100,000 in stock, after which the entire amount would be subject to changes in market value (see table).

B) Exercise and sell: This is the opposite scenario—you’d buy the stock and immediately sell it. (Some companies permit a cashless exercise, in which employee stock options are exercised without making any cash payment using a broker-assisted short-term loan.) Based on the numbers above, you’d realize $20,000 in profit, minus taxes and transaction costs (see table).

C) Sell to cover: In this middle ground, you’d buy all the stock and sell just enough of it to cover what you spent ($80,000), plus taxes and transaction costs. In other words, instead of realizing your $20,000 profit in cash, you’d realize it in stock (see table).



Number of shares exercised

Purchase price per share

Number of shares sold

Market price per share

Out-of-pocket cost

unrealized profit*

A. Exercise and hold







B. Exercise and sell







C. Sell to cover







*Does not reflect fees or taxes. Unrealized profit is the difference between the exercise price and the current market value of any unsold shares. Some companies may not allow “sell to cover,” but rather allow tendering shares back to cover the cost (often called “net exercise”). The example is hypothetical and provided for illustrative purposes only.

3. How are stock options taxed?

Employees are generally granted one of two types of options—incentive stock options (ISOs) or nonqualified stock options (NSOs)—and the main difference lies in how the spread is taxed. We’ll focus on federal taxes here, but applicable state taxes should also be a consideration.

With ISOs, you are not typically taxed when you exercise your options, but the spread is taxed when you sell your shares. If you hold the shares for more than one year past the exercise date and more than two years past the original grant date, the sale of the stock becomes a so-called qualifying disposition and any realized profit is typically taxed at the long-term capital gains rate. If you sell earlier, the spread will be taxed at your ordinary income rate, which for high earners can be as much as 37% at the federal level.

With NSOs, on the other hand, the spread is taxed as ordinary income in the year in which you exercise the options—even when you hold on to the shares—and companies usually withhold some of the proceeds to help pay applicable Medicare, Social Security and other taxes.

Unfortunately, the typical withholding rate is often too low, especially for high earners. Therefore, the smart move is often to pay estimated taxes or set aside additional money to cover any gap between the federal withholding rate and your estimated liability. Work with a qualified tax advisor for greater clarity.

On the surface, ISOs might seem like they offer employees more favorable tax treatment, but they come with a hidden risk: Regardless of when you sell, the spread will count as taxable income when calculating the alternative minimum tax (AMT) in the year you exercise your options, which could result in a larger overall income tax liability. Calculating your AMT is tricky, so be sure to consult an accountant or tax advisor before exercising your ISOs.

Do your homework

Equity compensation is an opportunity for you to participate in the future of the company you work for. It can also be a great way to get into the market—so long as you understand the tax ramifications of exercising your options and the effect the shares could have on your overall investment strategy. When in doubt, consult a financial advisor before making any decisions.

1The September 2017 survey, conducted by Koski Research for Schwab Stock Plan Services, is based on interviews with respondents 25–70 years old who participated in their employer’s equity compensation plan. Koski Research is neither affiliated with, nor employed by, Schwab Stock Plan Services.

What You Can Do Next

  • Discuss your employer stock options with a Certified Financial Planner™ professional when you enroll in Schwab Intelligent Portfolios Premium™. Get started now.