Employee stock options can come with expensive risks

Personal Finance

Taxation of stock options depends on what kind you have, and how long you hold those options before selling them. There are incentive stock options (which must meet specific rules under the tax code) and non-qualified stock options (pretty much everything that isn’t an ISO).

For non-qualified stock options, generally speaking, you pay taxes when you exercise those options, based on the difference between the so-called exercise price — the amount you were promised you could buy the stock for — and the fair market value at that time. That difference is taxed as ordinary income and subject to payroll taxes, and gives you an adjusted taxable basis of that fair market value.

Say you are awarded 100 stock options worth $50 per share ($5,000 total) and you exercise the options when they each are worth $100 ($10,000 total). You would pay tax on the difference, or $5,000 (your gain).

Then when you sell the shares, you’ll have either a short- or long-term capital gain or loss based on the difference between that adjusted basis and the sale price. For short-term gains, you pay your ordinary income tax rate. For long-term gains, the tax rate is either zero percent, 15 percent or 20 percent, depending on your annual income.

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