How to Exercise Your Company Stock Options

A stock option provides an individual with the right, but not the obligation, to purchase a company’s shares at a predetermined price within a specific timeframe. This compensation tool allows employees to potentially benefit from the company’s growth without immediately owning the stock. The initial grant of an option establishes the terms under which these shares can be acquired. This article guides individuals through exercising stock options, covering grant terms, tax implications, and procedural steps.

Understanding Your Stock Options

Before exercising stock options, understand the specific details of your grant. The grant date marks the day the company awarded you the options, setting the terms for your potential purchase. The strike price, also known as the exercise price, is the fixed price at which you can buy the company’s stock, regardless of its future market fluctuations. This price is set on the grant date.

The vesting schedule dictates when your options become available for purchase. Options vest over a period, such as 25% annually over four years, meaning you earn the right to exercise a portion of your options over time. Only vested options can be exercised; unvested options are forfeited if you leave the company.

The expiration date is the final day you can exercise your options. This date is several years after the grant date, often up to 10 years, though it can be shorter if you leave the company. Comparing your strike price to the current market price of the stock helps determine if your options are “in the money,” meaning the market price is higher than your strike price, making them valuable to exercise. Identify your company’s plan administrator or brokerage, such as Carta, Fidelity, or ETRADE, as this platform will manage your options.

Choosing an Exercise Method

Once you understand your stock options, choose an exercise method that aligns with your financial situation and goals. There are three common approaches to exercising options, each with distinct financial mechanics. The choice of method impacts your immediate cash outlay and how many shares you ultimately hold.

The first method is a cash exercise, also known as “exercise and hold” or “buy and hold”. This approach requires you to use your own funds to pay the strike price for the shares you wish to acquire. For example, exercising 1,000 options with a $10 strike price would require $10,000 in cash. This method is suitable if you intend to hold the shares for potential long-term growth and capital gains.

A second option is a cashless exercise, often referred to as “sell-to-cover”. In this method, you do not need upfront cash. Instead, a portion of the shares acquired upon exercise are immediately sold to cover the strike price, taxes, and transaction fees. The remaining shares are then deposited into your brokerage account. This approach results in you receiving fewer shares than you exercised.

The third method is a sell all exercise, also known as a “same-day sale” or “exercise and sell”. This involves exercising your options and immediately selling all the resulting shares. The proceeds from the sale, after deducting the strike price, taxes, and fees, are paid to you in cash. This method is chosen if you want to realize immediate liquidity from your options and do not wish to hold the company’s stock.

Tax Implications of Exercising

The tax consequences of exercising stock options are complex and depend on the type of option granted: Non-Qualified Stock Options (NSOs) or Incentive Stock Options (ISOs). Consulting with a tax professional is strongly recommended.

For Non-Qualified Stock Options (NSOs), the “bargain element” is taxed as ordinary income at the time of exercise. The bargain element is the difference between the fair market value of the stock on the exercise date and the strike price. This amount is subject to federal, state, and payroll taxes (Social Security and Medicare). Employers withhold these taxes at exercise, and this income is reported on your Form W-2. When you later sell the shares, any additional gain or loss beyond the fair market value at exercise is treated as a capital gain or loss.

Incentive Stock Options (ISOs) receive more favorable tax treatment, but they have specific rules. There is no regular income tax due at the time of exercise for ISOs. However, the bargain element from exercising ISOs is considered income for Alternative Minimum Tax (AMT) purposes. This means you might owe AMT even if you do not sell the shares immediately. Your employer will provide Form 3921, which reports details of your ISO exercise.

The tax treatment of ISOs upon sale depends on whether it’s a “qualified disposition” or a “disqualifying disposition”. A qualified disposition occurs if you sell the shares more than two years after the grant date and more than one year after the exercise date. If these holding periods are met, the entire gain (difference between sale price and strike price) is taxed at the lower long-term capital gains rates. A disqualifying disposition happens if you sell the shares before meeting both holding period requirements. In such a case, the difference between the strike price and the fair market value at exercise is taxed as ordinary income, similar to NSOs, and any additional gain is taxed as a capital gain.

The tax impact also varies by exercise method. With a cash exercise, the ordinary income (for NSOs) or AMT (for ISOs) is due at exercise, and capital gains are realized only when the shares are later sold. For a cashless exercise, the taxes due at exercise are covered by the sale of a portion of the shares. In a sell all exercise (same-day sale), the entire gain is realized immediately, and the ordinary income or AMT is applied and withheld at the time of the sale. This transaction is reported on both your W-2 as wages and on Form 1099-B as a stock sale, which requires careful reporting to avoid double taxation.

Steps to Exercise Your Options

After reviewing your option grant details, chosen exercise method, and tax implications, the next step is to execute the exercise. This process involves interacting with your company’s designated plan administrator or a third-party brokerage firm. Most provide an online portal for managing your equity.

Begin by logging into the online platform where your stock options are managed. Navigate to the section related to stock options or equity awards, often labeled “Exercise Options” or similar. Input the number of options you wish to exercise. The platform will prompt you to select your preferred exercise method from the available choices, such as cash exercise, cashless (sell-to-cover), or sell all (same-day sale).

Before finalizing the transaction, review all the details presented on the screen, including the number of shares, the chosen exercise method, and any estimated costs or proceeds.

If you selected a cash exercise, ensure sufficient funds are available in your linked brokerage account or arrange for a wire transfer to cover the strike price and any associated fees and taxes.

After confirming the details, submit your exercise request through the platform. You should receive a confirmation of your submission. The shares settle and appear in your account within a few business days. Keep records of all transaction confirmations and related documents for your financial and tax records.