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HomeWealth ManagementHow Do Stock Options Work? Everything You Need To Know!

How Do Stock Options Work? Everything You Need To Know!


  • Expiration Date: January 1, 2031

According to this vesting schedule, starting January 1, 2023, you have the option to buy up to 250 shares of The Cheesecake Factory at $40 per share. You’ll need $10,000 in cash if you decide to buy 250 shares. If the stock price of The Cheesecake Factory is $50 per share during that time, then your shares could be worth $12,500. Your “instant profit” would be $2,500.

What are the two types of stock options?

The two types of stock options are non-qualified stock options (NSOs) and incentive stock options (ISOs). ISOs have better tax benefits than NSOs, but have more restrictions attached to it.

What are non-qualified stock options (NSOs)?

Non-qualified stock options (NSOs) are stock options that do not qualify for special tax treatment. You will have to pay ordinary income taxes once you exercise the stock option.

In the example above, if you exercise your NSO on January 1, 2023 and buy The Cheesecake Factory stock at the exercise price ($40) and the stock price then is $50 (fair market value), then you have to pay ordinary income tax on the spread: the difference between the fair market value and the exercise price. In this case, the spread is $10 per share, and if you buy 250 shares, you have to pay ordinary income taxes on $2,500.

What are incentive stock options (ISOs)? 

Incentive stock options (ISOs) are stock options that qualify for special tax treatment. You don’t have to pay ordinary income taxes once you exercise the stock option. If you hold the stock for at least a year after purchase before selling, then you only have to pay long-term capital gains tax, which is lower than ordinary income taxes. 

Long-term capital gains tax rates for most middle/upper middle class Americans is 15%, and ordinary income tax rates for most middle/upper middle class Americans is 24% or 32%.

In the example above, if you exercise your ISO on January 1, 2023 and buy The Cheesecake Factory stock at the exercise price ($40) and the stock price then is $50 (fair market value), no taxes are due.

If you decide to sell the stock on February 1, 2024 (you’ve held it for more than a year), and the stock price then is $55, you have to pay capital gains tax on your stock price gains, which is $15 per share ($55 less your $40 exercise price).



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