Stock options can be a nice employer perk, but what does that mean for the employees come tax time? We’ll explain capital gains and stock options.
Capital Gains
When you sell a capital asset like stocks, bonds, or real estate for more than the price you paid for it, the profit is known as a capital gain. Capital gains are taxed depending on how long you’ve owned the asset before selling it. If you have held it for a year or less, you’ll pay short-term capital gains tax; for more than a year, you’ll pay long-term capital gains tax. Long-term capital gains are taxed at a lower rate than short-term.
Short-term capital gains are taxed as ordinary income, up to 37% for 2022, depending on your tax bracket. Long-term capital gains are taxed according to graduated thresholds for taxable income at 0%, 15%, or 20%. According to the IRS, most individual taxpayers pay a tax rate on net capital gains of no more than 15%.
Stock Options
Stock options are a form of compensation that companies offer to employees. The options are a contract that gives the employee the right to buy a set number of shares of the company’s stock at a pre-set price or a grant price that is lower than the cost to buy them on the stock market.
The options don’t give the holder an ownership interest but exercising them to buy the stock does. There are two types of stock options:
- Statutory stock options are granted under an employee stock purchase plan or an incentive stock option (ISO) plan.
- Non statutory stock options, also called non-qualified stock options (NSOs), are granted without any type of plan.
Capital Gains and Stock Options
Employee stock options are not taxable when granted. Taxation begins when the options are exercised, and the taxes are calculated based on the spread between fair market value and the exercise price. Taxes are also paid when the shares are sold. Taxation is handled differently for ISO and non-qualified stock options:
- ISOs: The alternative minimum tax (AMT) can apply when employees exercise their ISOs if the fair market value is higher than the exercise price. Long-term capital gains taxes apply if the stocks are held for more than a year before being sold. They are taxed as ordinary income if held for a year or less.
- NSOs: Ordinary income tax is withheld at the time of exercising the options. Long-term capital gains taxes apply if the stocks are held for more than a year before being sold. If held for a year or less, they are taxed as ordinary income.
As you can see, it’s important to hold stocks purchased under an employer’s stock options program for at least a year, whether they’re ISOs or NSOs, so you’re taxed at the more favorable long-term capital gains rate.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
