What is a stock option?

A stock option is a contract that gives the holder the right—but not the obligation—to buy or sell shares of stock at a predetermined price (the strike price) within a specific time period. Options can be purchased directly through the market but often are provided as a benefit from an employer.

But how does a stock option work? Find out what the different types of stock options are, how they are taxed and whether you should exercise your stock options.

When you receive or purchase a stock option, you have the opportunity to buy or sell that stock at a fixed price within a specific timeframe, regardless of whether the market price increases or decreases later during that same period of time.

In the broader stock market, there are two main types of stock options. Call options give you the right to buy stock, often when you believe the stock price will rise. Put options give you the right to sell a stock, often when you believe the stock price will fall or you want protection in case it does.

Employee stock options are a type of call option. Instead of being purchased as an investment, they're granted by an employer as part of a compensation package. The rest of this article focuses on employee stock options.

If your stock option came from your employer, you typically paid nothing upfront. This means you lose nothing extra because you didn’t pay for it to begin with. If you forget or voluntarily opt out of exercising the stock option before it expires, the option expires and you lose the potential gain. You’ll have made no profit, have no shares and won’t pay taxes on it.

However, if you did exercise the option, now you’ve turned the option into an actual stock ownership.

There are a few key components that define how this works.

Let’s say your strike price was $20, and the stock price was $30. You decide to exercise and buy shares at the lower, fixed rate. You now own shares worth $30, which means you have a $10 gain per share and you’re in the money. Because you bought it, you don’t have to worry about the expiration date anymore.

You can choose to sell your stock to lock in the $10 profit. Or, hold on to it to see if the price increases (or decreases). If the stock falls to a lower price, you still would own the stock but now at a loss. You’re out of the money. The downside of exercising is that you now take on full market risk just like any other investor.

However, you do have more than just these two options, including exercising vested options. Depending on the employer, even employees leaving a company can take advantage of a vesting schedule.

Stock options come in different forms, whether as employee compensation or as investment tools. As noted earlier, investors may encounter call options and put options, which are traded in the market. Common forms of employee stock-based compensation include restricted stock units (RSUs), non-qualified stock options (NSOs or NQSOs), incentive stock options (ISOs) and employee stock options (ESOs).

RSUs are a form of stock-based compensation that grant shares directly once they vest. Unlike stock options, you don’t need to purchase shares at a strike price to receive them.

For example, after one year, you might automatically receive 25% of your RSUs. After four years, you would own 100% of the fully vested shares. If you leave the company before all of your RSUs vest, what happens to the remaining RSUs depends on your employer’s plan, though many plans cancel any unvested awards.

Because RSUs are delivered automatically, you don't need to decide when to exercise them or worry about the expiration date.

NSOs, the most common type of stock option, can be granted to employees, contractors and advisors. NSOs are taxed as ordinary income at exercise without special holding requirements. They’re also easier to administer and more predictable.

Let’s say you’re a contracted church business administrator working for a large, nonprofit church, and you’re managing operations (ex. budgeting, payroll, vendor contracts).

In your compensation package, the church offers 1,000 NSOs at a strike price of $5 per share. Your vesting schedule is 25% per year over the course of four years. By year two, 500 NSOs would have been vested and are available to use.

If the church grows, maybe the share value becomes $15 per share. With a strike price of $5 and a current value of $15, you’re looking at a gain of $10 per share taxed as ordinary income. At $10 per share and 500 shares, the taxable income would be $5,000.

After exercising some of the vested options, you’ll own the shares outright. You would have to pay capital gains tax on additional growth. If the shares decrease, as can be common with investing, you’ll take the loss. And if your contract ends, unvested options will be lost.

Vested options must be exercised within a limited window, often 90 days. Once you buy them, those shares are fully yours to keep or sell whenever you like.

Unlike NSOs, which can be granted to a broader group of recipients, ISOs are available only to employees and come with stricter rules. If requirements are met, there is no regular income tax. There’s also the potential for long-term capital gains treatment. However, you are required to hold shares for at least one year after exercising the stock option. You also must hold two years after the grant date.

For example, let’s say your strike price is $10. The stock price later increases to $30, which you now own. (This is not promised. The stock price could easily drop after you bought shares.) That means you have a $20 gain per share (before taxes).

While you may not pay regular income tax when you exercise, depending on how long you hold the stock, you could end up paying lower capital gains tax instead of a higher income tax. You also may trigger the alternative minimum tax (AMT), which creates a tax bill even if you haven’t sold the shares yet.

ESOs are employer-granted stock options that may be offered as part of a compensation package, usually when you join a company. ESOs are designed to align your financial success with the company’s growth and usually follow a vesting schedule.

For example, 25% of stock options may vest after one year of employment. The remaining 75% of stock options may be spread out on a monthly or annual basis for the next three years. If you leave the company, you typically only keep the portion that has vested during your employment.

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Just because your employer has given you a grant date does not mean you automatically owe taxes on stock. First, you generally have to exercise NSOs, ISOs or ESOs before obtaining shares. RSUs work differently because shares are delivered automatically once they vest.

Taxes come into play later, depending on:

●      When you exercise
●      When you sell the shares
●      What type of option you have

With RSUs, taxes are generally due when the shares vest and are delivered to you.

With NSOs, ordinary income tax is owed when you exercise based on the spread between the strike price and market price. Capital gains taxes may apply after selling stock.

With ISOs, there is no income tax at the exercise stage, but the spread may create AMT exposure. However, you will pay taxes at the long-term capital gains rate if all rules are met (when the stock is profitable). AMT may apply even if the stock price drops.

With ESOs, tax treatment depends on the type of option you receive. Most employee stock options are structured as either NSOs or ISOs, each with its own tax rules.

When you exercise and when you sell can dramatically change your tax outcome. Exercising and selling immediately may result in mostly ordinary income. Holding shares longer may qualify for lower capital gains rates.

Disclaimer: This is general educational information. Tax rules are complex and vary by situation. Consult a qualified tax professional for your specific tax-related situation.

There is no one-size-fits-all answer. Key factors to consider include the current stock price versus your strike/exercise price, the expiration date, your liquidity needs and your tax-year planning. Exercising is not always the right move, and sometimes it’s OK to let a grant date pass by. Make sure that exercising will not strain your financial stability.

But if you do exercise your stock option, pay attention to expiration dates sneaking up (i.e., stock options are worthless overnight), evaluate whether you’ll end up leaving a job with unvested options or end up holding on to declining stock for an extended period of time. The year you exercise can impact your tax bill. Strategic timing can help manage or reduce taxes.

Stock options can be a powerful financial tool as a general investor, employee or a contractor. However, before you consider this investment strategy, don’t be afraid to ask all the questions you need to fully understand how to invest, what happens when you buy and sell shares, how your taxes could be affected, and when it may be a better idea to hold off on certain stock. Understanding how they work puts you in a stronger position to make confident decisions.

Whether you've received stock options as part of a job offer or you're exploring options trading, our Thrivent team is here to help you understand how they fit into your financial picture. Reach out today to talk to a Thrivent financial advisor.