Stock options: NQSOs and ISOs

With stock options, you have the opportunity—but not the obligation—to buy company stock at a fixed price (known as the "award price"). Stock options are subject to a vesting schedule. The vesting schedule establishes the length of time you will need to be employed at your company before the ownership of the stock options shifts to you. Once vested, stock options will have value only if the current stock price is higher than the award price.

Ahead, we'll cover:
1.    Understanding your grant agreement
2.    How to exercise options
3.    How stock options are taxed: NQSOs vs. ISOs
4.    Cost basis and tax forms
5.    Common questions about stock options

The grant agreement you receive from your employer covers important details about your stock options, including:

• Your grant date. The grant date is when you've officially been granted your options. This date is important as it sets your vesting schedule and exercise periods (see below).
• Type of stock options. There are two main types of stock options: non-qualified stock options (NQSOs) and incentive stock options (ISOs).
• The award price for the grant. The award price is the fixed amount you'll pay for each share of stock (regardless of the stock price on the open market). An award price can also be referred to as a strike price, exercise price, option price, or grant price.
• The vesting schedule. A vesting schedule establishes the time frame in which stock options become available for you to purchase (which is called "exercising").
• The exercise period. This is the amount of time you have to exercise your options once they vest. In most cases, you'll have 10 years from the date of grant before your options expire.

Make sure to read and understand your full grant agreement. There are additional details about transferability, taxation, and more.

Exercising means using your options to buy shares of company stock at the award price. Let's say you have 2,000 options with an award price of $40 and the current stock market price is $50. The value lies in the difference between the award price and market price (known as the spread). Your potential profit is $20,000 (the $10 spread times 2,000 options)—and you commonly have three choices for what to do next:

1. Exercise and hold: You buy the stock and hold it. The entire amount is subject to changes in market value.
2. Exercise and sell: You buy the stock and immediately sell it. This is known as a cashless exercise, as no money is required out of pocket.
3. Sell to cover: You buy the stock and sell just enough to cover the cost of the purchase price, plus applicable taxes and transaction costs. In other words, instead of getting a profit in cash, you get it in stock.
   
   Prior to exercising or selling any shares, you'll want to carefully consider any applicable fees and the tax consequences. For advice, consult a tax advisor or a financial consultant.

Employees are generally granted one of two types of options—non-qualified stock options (NQSOs) or incentive stock options (ISOs)—and the main difference lies in how the spread is taxed.

Note: This section refers to U.S. taxation. International tax filers may have different obligations.

NQSOs

• 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.

ISOs

• You are not subject to ordinary income tax 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 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 tax rate.

On the surface, ISOs might seem like they offer more favorable tax treatment than NQSOs, but they come with a hidden risk: The spread when you exercised the option 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.
 

When filing your taxes, it's important to be mindful of the cost basis you report. Cost basis is the original purchase price you paid for shares (plus commissions, fees, and any transaction costs), but note that stock options are treated differently. In addition to the purchase price, the cost basis on NQSOs needs to be adjusted to include the spread. If you exercised your ISOs, you may need to keep track of more than one cost basis: one for ordinary income and another for AMT.

Using the correct cost basis ensures that you file correctly and aren't taxed more than the required amount. Refer to this cost basis sheet to help you determine the cost basis on your stock plan transactions so you can file your taxes accurately.

Tax forms

Those who have exercised stock options will receive IRS Form 1099-B (U.S. only).

Those who were granted ISOs will also receive the IRS Form 3291 (U.S. only).

1. What does it mean when stock options are "in the money" vs. "out of the money?"
When the current market price is higher than the award price your employer put in the grant agreement, your options are considered "in the money." If you were to buy the stock and then sell it on the open market, you would make an immediate profit.

When the market price dips below the award price, however, the stock options are "out of the money" or "underwater." In this situation, the stock options have no value, as it would cost you more to exercise your options than to buy them on the open market. Your Schwab One^® brokerage account will automatically recognize if your stock options are out of the money and prohibit you from exercising them.

2. Can I transfer my stock options to another person?
Generally, no. Stock options typically are non-transferrable, with the exceptions of your passing or a court order related to divorce. Refer to your stock option agreement for details about transfers.

3. What happens to my stock options if my employment ends?
Under most circumstances, a grace period provides the opportunity to exercise vested stock options after your termination date. A common grace period is three months, but it's determined by the terms of each grant. The reason for employment termination is also a factor. In some cases, there is no grace period and rights expire immediately.

4. What happens to my stock options if I die?
Generally, your heirs or the executors of your estate will have one year from the date of your passing to exercise your vested but unexercised options. Refer to your award agreement(s) for details. Remember to include your stock options and other equity awards in estate planning; if your company permits you to elect a beneficiary, consider doing so.

5. How do I know if I have stock options?
Your company will notify you when you receive stock options. Grant details are also located in the Equity Award Center. Log in to your Schwab account. From the Summary page under Accounts, scroll down to Employer Sponsored Equity Awards. If you have stock options, you will see a summary of those awards in this section.