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If you are reading this article, your company has probably granted you stock options. Stock options give you a potential share in the growth of your company's value without any financial risk to you until you exercise the options and buy shares of the company's stock. Moreover, while cash bonuses and most other forms of compensation are taxable when you receive them, stock options defer taxes until you exercise options. Before you exercise trading options, their built-in value is subject to options growth—which can be significant.

This article explains the basic facts and terms that you must know to make the most of your stock options. A stock option is a contractual right that a company awards under 101 stock planwhich contains the company's rules for its stock 101 grants. While some of the rules that govern stock options are dictated by tax trading securities laws, many variables in the ways option grants work are left for each company to provide in its stock plan and in the grant agreement that recipients must often accept.

Stock options give you the right to purchase a specified number of shares of the company's stock at a fixed price during a rigidly defined timeframe. The purchase is called the exerciseand the options price set at grant is called the exercise price.

Typically, you must continue to work at the company for a specified length of time before you are allowed to exercise any of the stock options.

That length of time is called the vesting periodwhich is characterized by a vesting schedule. Under a vesting schedulean option grant can be set up so trading it vests either all at once cliff vesting or in a series of parts over time graded vesting. The adjacent graphic illustrates the concept of a typical graded vesting schedule. While vesting periods for stock options are usually time-basedthey can also be based on the achievement of specified options, whether in corporate performance or employee performance see the FAQ on performance-based stock options.

Stock options always have a limited term during which they can be exercised. The most common term is 10 years from the date of grant. Of course, after the vesting period has elapsed, the actual amount of time to exercise the options will be shorter e. If the options are not exercised before the expiration of the grant term, they are irrevocably forfeited.

Employees who leave the company before the vesting date usually forfeit their options. With vested optionsdeparting employees typically have a strictly enforced timeframe often 60 or 90 days in which to exercise—they are almost never allowed the remainder of the original option term.

Since the exercise price is nearly always the company's 101 price on the grant date, stock options become valuable only if the stock price rises, thus creating a discount between the market price and your lower exercise price. However, any value in the stock options is entirely theoretical until you exercise them—i. After you have acquired the shares through this purchase, you options them outright, just as you would own shares bought on the open market.

Depending on the rules of your company's stock plan, options can be exercised in various ways. If you have the cash to do so, you can simply make a straightforward cash paymentor you can pay through a salary deduction. Alternatively, in a cashless exerciseshares are sold immediately at exercise to cover the exercise cost and the taxes. If your company's stock price rises, the discount between the stock price and trading exercise price can make stock options very valuable. That potential for personal financial gain, which is directly aligned with the company's stock-price performance, is intended to motivate you to work hard options improve corporate value.

In other words, what's good for your company is good for you. However, by the same token, stock options can lose value too. 101 the stock price decreases after the grant date, the exercise price will be higher than the market price of the stock, making it pointless to exercise the options—you could buy the same shares for less on the open market.

Options with an exercise price that is greater than the stock price are called underwater stock options. Companies can grant two kinds of stock options: A nonqualified stock option NQSO is a type of stock option that does not qualify for special favorable tax treatment under the US Internal Revenue Code.

Thus the word nonqualified applies to the tax treatment not to eligibility or any other consideration. NQSOs are the most common form of stock option and may be granted to employees, officers, directors, contractors, trading consultants.

You pay taxes when you exercise NQSOs. For tax purposes, the exercise spread is compensation income and is therefore reported on your IRS Form W-2 for the calendar year of exercise for an annotated diagram of W-2 reporting for NQSOs, see a related FAQ. Your company will withhold taxes—income tax, Social Security, and Medicare—when you exercise NQSOs. When you sell the shares, whether immediately or after a holding period, your proceeds are taxed under the rules for capital gains and losses.

You report the stock sale on Form and Schedule D of your IRS Form tax return for examples with annotated diagrams, see the related FAQs. For a detailed explanation of the tax rules, see the sections NQSOs: Taxes Advancedand the related sections of the Tax Center on this website. Incentive stock options ISOs qualify for special tax treatment under the Internal Revenue Code and are not subject to Social Trading, Medicare, or withholding taxes.

However, to qualify they must trading rigid criteria under the tax code. ISOs can be granted only to employeesnot to 101 or contractors. Also, for an employee to retain the special ISO tax benefits after leaving the company, the 101 must be exercised within three months after the date of employment termination.

After you exercise Options, if you hold the acquired shares for at least two years from the date of grant and one year from the date of exercise, you incur favorable long-term capital gains tax rather than ordinary income tax on all appreciation over the exercise price. However, the paper gains on shares acquired from ISOs and held beyond the calendar year of exercise can subject you 101 the alternative minimum tax AMT. This can be 101 if you are hit with the AMT on options gains but the company's stock price then plummets, leaving you with a big tax bill on income that has evaporated.

Stock option taxation is an important subject for all optionholders to understand. Now 101 you know the basic workings of stock options, you should learn the details of their tax treatment.

In the tax-related parts of this website's sections on NQSOs and ISOsyou will find articles and FAQs that explain the basics of stock option taxation thoroughly. For international employees, the Global Tax Guide has information on options tax treatment of stock options and other types of equity compensation in many different countries. Matt Simon is the copyeditor and content-manager at myStockOptions. Need options financial, tax, or legal advisor?

Search AdvisorFind from myStockOptions. Key Points Stock options give you a potential share in the growth of your company's value without any financial risk to you until you exercise the options and buy shares of the company's stock. Taxes on the value are deferred until exercise. Stock options give you the right to purchase exercise a specified number of shares of the company's stock at a fixed price during a rigidly defined timeframe.

Since the exercise price is nearly always the company's stock price on the grant date, stock options become valuable only if the stock price rises. Trading potential for personal financial gain, which is directly aligned with the company's stock-price performance, is intended to motivate you. Stock options give you a potential share in the growth of your company's value. An option grant can be set up so that it vests either all at once cliff vesting or in a series of parts over time graded vesting.

Stock options become valuable only if the stock price rises, thus creating a discount between the market price and your lower exercise price. ISO taxation is 101. You must understand how the alternative minimum tax can affect you. People who read this article also read: How To Avoid 101 Most Common Stock Option Mistakes Part 2 12 Tax-Return Mistakes To Avoid With Stock Options And ESPPs Stock Option Fundamentals Part 1: Know Your Goals And Terms Stock Option Fundamentals Trading 2: Vesting And Expiration Stock Option Fundamentals Part 3: Income Taxes And Withholding What Are My Stock Options Worth?

Stock Option Fundamentals Part 5: Exercise Methods Stock Option Terms: What You Can Expect How To Avoid The Most Common Stock Option Mistakes Part 1. Home My Records My Trading My Library. Tax Center Global Tax Guide Discussion Forum Glossary.

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