Stock options: NQSOs and ISOs

Stock Options: What Are They?

Stock Options: What Are They?

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Upbeat music plays throughout.

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Onscreen text:
Stock options: What are they? 

An animated scene inside an airport terminal. Outside, visible through a window, an airplane taxies in from the right while a woman walks into the scene from the left, rolling her suitcase. 

Female narrator: Investing is a journey. And stock options can be an important part of that journey that can help you get where you want to be.

The woman continues walking through the airport terminal, passing other travelers who are looking out a window at the plane rolling by. 

Narrator: They're a way to share in your company's success. Because when the company does well, so do your stock options.

The woman steps onto an escalator going up, passing posters on the wall along the way. 

Narrator: It's important to know that stock options aren't actually stock.

Onscreen text on the first poster:
WHAT ARE STOCK OPTIONS?
The option to buy shares of your company's stock at a specified price—called the award price

Narrator: They're the option to buy shares of your company's stock at a specified price—called the award price.

The woman studies the next poster and rests her chin in her hand, considering what she has just read.

Onscreen text on the second poster:
AWARD PRICE
The fixed price you'll pay for your shares

Narrator: No matter how much the stock price in the market might increase, you can still buy shares at your award price.

You earn your stock options over time, through a process called vesting.

Onscreen text on the third poster:
VESTING
This means earning your stock options over time.

Narrator: Once your options are vested, you have choices to make about when and how to exercise them.

As the woman passes the VESTING poster, she nods as if in agreement.

Onscreen text on the final poster:
EXERCISING OPTIONS
Purchasing your options of company stock—before they expire

The woman studies this final poster. She arrives at the top of the escalator and continues walking through the terminal.

Narrator: Exercising options means purchasing shares of your company stock. And you'll really want a plan for what you'll do with them before you exercise.

The woman passes others in the terminal. Then she pauses and moves her hand to her chin as if in thought. Three circles representing thought bubbles pop up above her head. The one on the left is navy with a bar graph; the one in the center is light blue with a calendar icon; and the one on the right is red with three dollar bills. The three circles then animate and merge together under the red circle featuring the money. The word "HOLD" appears on a monitor mounted near the windows.

Onscreen text:
HOLD

Narrator: When making that decision, it's important to consider the value of the stock price, when your options expire, and your personal or financial tax situation.

The red circle animates to show an icon of a certificate, and the woman starts walking again.

Narrator: It also helps to think about what you want out of your exercise after it settles. Do you want cash to spend? Or would you rather have company stock?

There are three common ways to exercise: hold, sell, and sell-to-cover.

The woman resumes walking, and next to the monitor saying "HOLD," two other monitors come into view. The two new monitors say "SELL" and "SELL-TO-COVER," respectively. The woman stops and looks up at the monitors.

The frame zooms in on the monitor that says "HOLD."

Narrator: "Hold" means buying your shares and keeping all of them. 

The word "HOLD" fades away and is replaced by a blue screen that has an icon of a stock certificated on the left. 

Onscreen text:
EXERCISE AND HOLD
If the market price dips below your award price, your shares will lose value.

Narrator: This gives your shares time to potentially gain value. But it can also be risky because there's no guarantee you'll make a profit. If, for example, the market price of the stock dips below your award price, your shares will lose value.

A dollar bill icon in a circle emerges from the stock certificate icon and moves up and down across the screen, mimicking the rise and fall of stock values.

The frame moves to the monitor containing the word "SELL" and zooms in. 

Onscreen text:
EXERCISE AND SELL
Money from sale of stock – Taxes = Your profit

A circle appears on the screen and a total of five dollar bills appear in it, one at a time.

Narrator: "Sell" means you exercise your options and immediately sell the purchased shares for cash. The money from the sale is yours after taxes, and you could use it to pay for a short-term financial goal or reinvest it, amongst other things.

The frame moves to the sign that says "Sell-to-cover" and zooms in. A circle appears that fills with three stock certificate icons.

Onscreen text:
SELL-TO-COVER (Partial Sell)
Exercise stop options [then] Sell just enough shares to cover price and taxes [then] Own shares without spending cash

Narrator: "Sell-to-cover" means you exercise your stock options, then immediately sell just enough of the shares you just bought to cover the price and taxes. In the end, you're left with shares you own that you didn't have to dip into your savings to buy.

Zooms out to show the woman looking up at all three monitors. In the background, an airplane takes off from the left [Rumble of the jet engines] and ascends to the right.

Narrator: And before you make any exercise decisions, think about your financial goals and how your stock options can help you reach them.

The screen split into two frames. On the left, the woman resumes walking through the terminal. On the right, a beach scene appears, featuring a white Adirondack chair and a tropical drink under a sunny sky.

Narrator: Do you need to build up a retirement savings fund?

The woman continues walking in the left screen, while the right screen transitions to a laptop computer surrounded by a lamp, coffee mug, pencil holder and eyeglasses. On the computer screen is a circle graph divided into sections of various colors and with a dollar sign in the center.

Narrator: Diversify your investments to potentially grow wealth?

The right side of the screen then transitions to a young girl and a dog standing in front a house with a "For Sale" sign in the yard. The woman walks from the airport terminal in the left screen into the yard and joins the girl and the dog. The left screen disappears as a "Sold" sign covers the "For Sale" sign and the woman puts her arm around the girl. The dog wags its tail and barks.

Narrator: Or save for a home? 

When you're ready to make your move, log in to the Equity Award Center to exercise your options.

A white screen fills and gray text appears.

Onscreen text:
Still have questions?
Call a Schwab Stock Plan Specialist at 800-654-2593.
International Participants, call +1-602-355-3408.

Narrator: Still have questions? Give us a call.

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INVESTING INVOLVES RISK, INCLUDING LOSS OF PRINCIPAL.
Schwab Stock Plan Services provides equity plan services and other financial services to corporations and employees through Charles Schwab & Co., Inc. ("Schwab"). Schwab, a registered broker-dealer, offers brokerage and custody services to its customers.

©2023 Charles Schwab & Co., Inc. All rights reserved. Member SIPC. CC7077878 (0123-2HAB)

 

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Stock options

With stock options, you have the opportunity—but not the obligation—to buy company stock at a fixed price (known as the "award price"). Stock options are subject to a vesting schedule. The vesting schedule establishes the length of time you will need to be employed at your company before the ownership of the stock options shifts to you. Once vested, stock options will have value only if the current stock price is higher than the award price.

Understanding your grant agreement

The grant agreement you receive from your employer covers important details about your stock options, including:

  • Your grant date. The grant date is when you've officially been granted your options. This is important as it sets your vesting schedule and exercise periods (see below).
  • The number of stock options and the type you have been granted. There are two main types of stock options: non-qualified stock options (NQSOs) and incentive stock options (ISOs).
  • The award price for the grant. The award price is the fixed amount you'll pay for each share of stock (regardless of the stock price on the open market). An award price can also be referred to as a strike price, exercise price, option price, or grant price.
  • The vesting schedule. A vesting schedule establishes the time frame in which stock options become available for you to purchase (which is called "exercising").
  • The exercise period. This is the amount of time you have to exercise your options once they vest. In most cases, you'll have 10 years from the date of grant before your options expire.

Make sure to read and understand your full grant agreement. There are additional details about transferability, taxation, and more.
 

How to exercise your options

Exercising means using your options to buy shares of company stock at the award price. Let's say you have 2,000 options with an award price of $40 and the current stock market price is $50. The value lies in the difference between the award price and market price (known as the spread). Your potential profit is $20,000 (the $10 spread times 2,000 options)—and you commonly have three choices for what to do next:

  1. Exercise and hold: You buy the stock and hold it. The entire amount is subject to changes in market value.
  2. Exercise and sell: You buy the stock and immediately sell it. This is known as a cashless exercise, as no money is required out of pocket.
  3. Sell to cover: You buy the stock and sell just enough to cover the cost of the purchase price, plus applicable taxes and transaction costs. In other words, instead of getting a profit in cash, you get it in stock.

Prior to exercising or selling any shares, you'll want to carefully consider any applicable fees and the tax consequences. For advice, consult a tax advisor or a financial consultant.
 

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NQSOs

Taxation at exercise

With nonqualified stock options (NQSOs), taxes typically come into play twice—when you exercise the options and when you sell them.
 
The price you pay when you exercise your options is called the "award price." The "spread" is the difference between the award price and the market price on the day you exercise. If you exercise your NQSOs and sell the stock in a single transaction, your spread is taxed as ordinary income, and your company will usually withhold taxes. You're subject to ordinary income taxes on the spread when you exercise, regardless of whether you also sell at the same time. 
 
For example, if you exercise 100 vested NQSOs at an award price of $1 per share and you sell at a market price of $10 per share, you’ll pay ordinary income tax on the $900 gain at exercise. 
 
We recommend consulting with a tax professional on your individual situation. 
 

A graphic represents a spread of 100 exercised NQSOs with an award price of $1 and a market price of $10, showing a $900 gain.

Taxation at sale

With NQSOs, you're taxed on any increase in value you realize when you sell.

For example, if the market price is $15 per share at the time you exercise and then has risen to $20 per share when you sell, that $5-per-share increase would be subject to ordinary income tax or capital gains tax. The amount you will pay in taxes depends on how long you hold the shares after the grant and exercise dates.  

If you sell your shares within a year of exercising, you'll likely pay ordinary income tax on the short-term capital gains profit you make.

If you hold your shares for at least a year (plus one day) before selling them, you'll likely pay long-term capital gains taxes, which typically have a lower rate than short-term capital gains, on the profit you make selling your shares.  

If the market price falls and you sell at that lower price, that's a capital loss, and you won't owe any taxes.

A graphic represents a spread of NQSOs with a market price of $15 when exercised and a market price of $20 when sold, showing a $5 increase per share.

Forms you'll need

The following forms apply to U.S. taxation. If you're an international tax filer, you'll have different obligations—and may need different forms—based on the country you live in.

Log in to your Schwab brokerage account. From the Accounts page, select Statements to access yours.

These forms are completed for you:

  • W2 from your company that reports ordinary income and taxes paid on your behalf
  • 1099-B Composite Statement from Schwab that reports shares you've sold in your Schwab brokerage account

These forms you need to complete yourself:

  • Form 8949 from the IRS that reports ordinary income received and taxes paid on your behalf
  • Schedule D from the IRS that reports the totals from Form 8949

We recommend consulting with a tax professional on your individual situation.

4 boxes make a grid. Each box features a different form that is needed to apply for taxation.

ISOs

Taxation at exercise

Exercising incentive stock options (ISOs) may trigger something called the alternative minimum tax (AMT), so check with your tax advisor or do an AMT calculation before you exercise ISOs.

For example, if you exercise 1,000 shares at $1 each when they're worth $5 each, you need to add $4,000 to your income to calculate the AMT. 

A graphic represents 1,000 exercised ISOs at an award price of $1 and a market price of $5. The calculation shows a $4,000 addition to income when calculating AMT.

Taxation at sale

You're taxed on any increase in value you realize on your investment when you sell. How much of each type of tax depends on whether your sale is a qualifying or disqualifying disposition.

A qualifying disposition means the sale occurred after you had held your shares for at least two years from the date your ISOs were granted and one year after exercising your ISOs. With a qualifying disposition, the difference between the value of the shares when you exercised them and the price at which you sold them will be taxed at a more preferential long-term capital gains rate.

If either of these qualifications isn't met, the sale is considered a disqualifying disposition. A disqualifying disposition receives a less favorable tax treatment: The difference between the fair market value on the date you purchased your stock and the purchase price is taxed as ordinary income.

A two column graphic features a definition of a qualifying disposition on the left and a disqualifying disposition on the right.

Forms you'll need

These forms apply to U.S. taxation. If you're an international tax filer, you'll have different obligations—and may need different forms—based on the country you live in.

Log in to your Schwab brokerage account. From the Accounts page, select Statements to access yours.

These forms are completed for you:

  • W2 from your company that reports ordinary income and taxes paid on your behalf
  • 1099-B Composite Statement from Schwab that reports shares you've sold in your Schwab brokerage account
  • Form 3921 from Schwab with details from your ISO exercise

These forms you'll need to complete yourself:

  • Form 8949 from the IRS that reports ordinary income received and taxes paid on your behalf
  • Schedule D from the IRS that reports the totals from Form 8949

We recommend consulting with a tax professional on your individual situation.

A grid of five boxes each feature a different form that is needed to apply for taxation.

Cost basis and tax forms

When filing your taxes, it's important to be mindful of the cost basis you report. Cost basis is the original purchase price you paid for shares (plus commissions, fees, and any transaction costs), but note that stock options are treated differently. In addition to the purchase price, the cost basis on NQSOs needs to be adjusted to include the spread. If you exercised your ISOs, you may need to keep track of more than one cost basis: one for ordinary income and another for AMT. 

Using the correct cost basis ensures that you file correctly and aren't taxed more than the required amount. Refer to this cost basis sheet to help you determine the cost basis on your stock plan transactions so you can file your taxes accurately.

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Tax forms

Those who have exercised stock options will receive IRS Form 1099-B (U.S. only).

Those who were granted ISOs will also receive the IRS Form 3291 (U.S. only).

Common questions about stock options

1

What does it mean when stock options are "in the money" vs. "out of the money?"

When the current market price is higher than the award price your employer put in the grant agreement, your options are considered "in the money." If you were to buy the stock and then sell it on the open market, you would make an immediate profit.

When the market price dips below the award price, however, the stock options are "out of the money" or "underwater." In this situation, the stock options have no value, as it would cost you more to exercise your options than to buy them on the open market. Your Schwab One® brokerage account will automatically recognize if your stock options are out of the money and prohibit you from exercising them.

2

Can I transfer my stock options to another person?

Generally, no. Stock options typically are non-transferrable, with the exceptions of your passing or a court order related to divorce. Refer to your stock option agreement for details about transfers.

3

What happens to my stock options if my employment ends?

Under most circumstances, a grace period provides the opportunity to exercise vested stock options after your termination date. A common grace period is three months, but it's determined by the terms of each grant. The reason for employment termination is also a factor. In some cases, there is no grace period and rights expire immediately.

4

What happens to my stock options if I die?

Generally, your heirs or the executors of your estate will have one year from the date of your passing to exercise your vested but unexercised options. Refer to your award agreement(s) for details. Remember to include your stock options and other equity awards in estate planning; if your company permits you to elect a beneficiary, consider doing so.

5

How do I know if I have stock options?

Your company will notify you when you receive stock options. Grant details are also located in the Equity Award Center. Log in to your Schwab account. From the Summary page under Accounts, scroll down to Employer Sponsored Equity Awards. If you have stock options, you will see a summary of those awards in this section.

Have more questions about your stock options? We're available 24 hours a day, Monday through Friday.

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