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Employee stock options are a popular way to recruit and incentivize employees by allowing them to participate in the upside success of a company, acting as an additional form of compensation or bonus with the potential to increase in value as a firm grows.

Generally, you would be issued or “granted” stock options by your company as part of an employee stock option plan. To understand how they work, let’s first look at some common terminology.

• Grant amount:��This is the number of shares of stock you are allowed to buy.
• Grant price:��This is the price you have to pay per share.
• Issue date:��The date that the grant was issued.
• Expiration date:��The date by which you have to purchase the stock, should you choose to.
• Exercise date:��The date on which you actually purchase the stock.

Let’s look at a hypothetical example to see how this works.

Your employer grants you the option to buy 1,000 shares of your company stock on Jan. 1, 2022, at a price of $20 per share. You are given until Jan. 1, 2032, to decide if you wish to exercise this grant. Then, on March 1, 2027, your company’s stock reaches $40 per share, so you decide to exercise your option to purchase the stock at $20 per share.

In this case:

• Your��grant amount��was 1,000 shares.
• Your��grant price��was $20 per share.
• Your��issue date��was Jan. 1, 2022.
• Your��expiration date��was Jan. 1, 2032.
• Your��exercise date��was March 1, 2027.

As you can see, one of the benefits of employee stock options is that you don’t have to commit to buying shares ahead of time. As the name implies, you are given the “option” to buy the shares, which means it’s the closest you can get to a sure thing. If the share price never rises past the grant price, you don’t exercise your options, and if it does, you have a guaranteed profit.

If you decide to exercise your options before the expiration date, you generally have two different ways to go about it: You can pay cash or do a cashless exercise, which is also known as a “same-day sale.”

In the example above, if you wanted to do a cash purchase, you would simply deposit funds with your broker to cover the cost of the shares, in this case, $20,000 – the grant amount multiplied by the grant price. You would then own 1,000 shares of your company stock, which you could then either sell or hold as long as you want.

For a cashless exercise, you could exercise your options and sell just enough to cover the cost of the purchase. Again, using the example above, you would exercise the option for all 1,000 shares and sell half of them to cover the $20,000 purchase cost, leaving you with 500 fully paid-for shares.

Your brokerage firm can do these two transactions simultaneously, though it might charge a commission or processing fee.

There are two main types of stock options that companies award to their employees:

1. Incentive stock options
2. Nonqualified stock options

The main difference between the two is how profits are taxed.

When you exercise NSOs, the difference between the grant price and the current price that the shares are trading for is considered a profit, even if you don’t sell the shares. And that profit is considered ordinary income, which means your employer will generally withhold federal and state income tax as well as Social Security and Medicare.

This can lead to major problems if you don’t plan accordingly. For example, if you exercise NSOs but don’t sell the shares you receive, you will still be taxed on the “profits,” and if the shares then drop and trade below your grant price, you could end up paying taxes on money that you never actually received.

In contrast, ISOs have a more favorable tax treatment because they are not taxed when exercised. In addition, if you hold your shares for more than one year from exercise and for more than two years from the original grant date, your profits are taxed as capital gains instead of ordinary income.

With most plans, if you leave your company, you have 90 days to exercise any vested stock options at their grant price. If you don’t, they will expire along with any unvested options. You already own any stock shares purchased through the employee stock option plan, so nothing changes there.

Employee stock option plans are just one of the three common ways for companies to provide stock options to employees. The other two are employee stock ownership plans and employee stock purchase plans. Although the terms sound very similar, it is important to clarify the difference between these three plans.

An employee stock ownership plan, also called ESOP, is a retirement plan similar to a 401k in which the company contributes to the plan in the form of its stock. The assets are held in a trust for employees, and they accrue shares in the plan over time. As the employee/participant, you do not buy or hold the stock directly. You are typically only paid out upon either termination or retirement from the company, and you can choose to roll over the funds at that time or take the distribution (with tax implications). These are often attractive to companies due to being highly tax-advantaged and to help retain employees through long-term wealth and aligned goals.

Employee stock purchase plans are a form of equity compensation in which employees can designate a regular payroll deduction to then purchase company stock. There are several rules associated with these plans, including who can participate, how much you can purchase and if the company chooses to discount the price at the offering period. Because these are not tied specifically to a retirement account, employees can��choose to hold or sell the stock��as they please; however, there are different tax incentives for holding it longer.

Although these can seem advantageous, we generally recommend that you don’t have more than 5% in any one stock, especially your employer’s stock, because you do not need more than that to achieve diversification. In addition, being overconcentrated in one security can cause unnecessary volatility and risk with your retirement savings. You also have the benefit of reducing what’s called company-specific or idiosyncratic risk – the risk that any one thing goes wrong with any one company.