A growing number of companies figure that employees will perform better if they have something more to gain.
Such stock ownership comes in several forms, ranging from stock purchase plans to 401(k) plans to broadly granted stock options.
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Stock option plans were once used just to reward top management and other key players. But more and more companies are using stock option plans to reward – and retain – a wide range of workers. In the last 25 years, the number of people holding stock options has increased about nine-fold, according to the National Center for Employee Ownership.
Understanding Your Employee Stock Options
A stock option isn’t an award of stock. A stock option simply gives the employee the right to buy a certain number of shares at a fixed price for a certain number of years.
For instance, you may be given an option to buy company stock at $5 a share (called the ‘grant price’) anytime over the next 10 years. The idea is that you can quickly profit by buying the stock (i.e. exercising your option) and selling it, usually on the same day – if not within the same hour.
Note that some stock options are ‘phased in.’ For example, your company may grant you a total of 1,500 shares, which are distributed as 300 shares a year over 5 years. Many companies won’t allow you to exercise your stock options until you’ve worked there for a certain period of time.
When Should You Exercise Your Stock Options?
Many people wait until just before the option expires — assuming the market price is higher than the grant price. You may also want to exercise your option if the value of the stock represents more than 10%-20% of your net worth. After all, you don’t want all your eggs in one basket.
The tax consequences of exercising your stock options can be complicated. In some circumstances, your profits are taxed at the capital gains rate. In other circumstances, the profits are taxed at higher rates as ordinary income.