We have covered Restricted Stock Units (RSUs) and Employee Stock Purchase Plans (ESPPs) before. This week I will talk about another type of stock compensation - Non-qualified Stock Options (NSOs or NQSOs).

Basically, NSOs give employees the right to purchase a certain number of shares of the company's stock at a predetermined price in a specific period. And It does not meet certain requirements set by the IRS to be classified as Incentive Stock Options (ISOs) and receive certain favorable tax treatments which I will cover next month. Here are five things I think you need to know about your NSOs.

1. Vesting Schedule

Like employer's contribution to your 401(k) accounts, NSOs do not belong to you until vested. In general, your vesting schedule either falls under a "cliff" schedule (100% of your NSOs will be vested at the same time after a certain period) or a "graded" schedule (your NSOs will be vested gradually, e.g., 25% per year and vested in four years). More importantly, you need to understand what will happen to your vested and unvested NSQs when you leave the company. Sometimes it may be worthwhile to stay until more NSOs are vested.

2. Expiration date

NSOs will expire if not exercised before the expiration date. The most common term is ten years from the date of grant. In other words, if you have a four-year "cliff" vesting schedule, you will only have six years to exercise unless you are allowed to exercise before vesting which will be covered later. Also, the original expiration date rarely applies once you leave the company. You usually only have sixty or ninety days to exercise your vested NSOs from your last day at the company.

3. Taxation

NSOs will be taxed upon exercising and selling, not at granting or vesting. When you exercise your NSOs, the difference between the market value of the stock and your exercise price will be taxed as ordinary income and is subject to Social Security, Medicare, federal, and state income tax withholdings.

Similar to RSUs, many companies withhold federal income taxes on NSOs at a flat rate of 22% (37% for amount over $1 million). If your marginal tax bracket is higher than 22% excluding NSOs, you are most likely not withholding enough. You need to either increase withholding amount from each paycheck by adjusting your W-4 if possible or make quarterly estimated tax payments to avoid a potential penalty for underpayment of estimated tax. Some companies use the same tax rate from your W-4 for your NSOs tax withholdings. If this is the case, you are less likely to have the underpayment of estimated tax issues. If you are not sure, I recommend you consult a tax professional based on your specific situation.

At the time you sell the stocks you exercised, the difference between the selling price and the market price of the stocks at exercising will be treated as long-term or short-term capital gains/ losses depending on your holding period.

You can control when to be taxed and even how much taxes you will owe by planning the time and the number of shares to exercise and sell.

4. Early Exercise and 83(b) election

Generally, you can only exercise your NSOs after vesting as unvested NSOs are not yours in theory. However, some companies allow you to exercise your NSOs before vesting and make 83(b) election. Basically, by doing this, you can control the timing of the taxation upon exercising even before vesting. It can potentially benefit or hurt you depending on the stock price.

For example, you have 100 NSOs which will be all vested in two years. The exercise price of your NSOs is $10 per share. The current market price of the stock is $20 per share. You exercised all your 100 unvested NSOs today. $1,000 = ($20-$10)*100 will be taxed as ordinary income in the current year. Two years later, if the market price of the stock increases to $40 per share, $2,000=($40-$20)*100 will be taxed as long-term capital gains. In contrast, if you exercise upon vesting, all $3,000=($40-$10)*100 will be taxed as ordinary income. However, if the stock market price drops to $5 per share two years from now, you won't be able to get back all the taxes you have paid on the $1,000 ordinary income in the current year.

5. Options Exchange

Unlike regular public traded stock options, there is no secondary market for NSOs. When the market price is lower than the exercise price of the NSO, the NSO becomes almost worthless at that time. Some companies may give you an option to exchange your old "underwater" NSOs for new NSOs or even other types of stock compensations like RSUs. This type of program is usually called an options exchange.

Very few companies like Google also offer another type of program that allows you to sell your NSOs to financial institutions through an online auction.

These alternative programs are very company specific. You need to learn the details of all the programs available to you, compare them and then make decisions based on your specific situation.

In summary, NSOs are more complex than RSUs and ESPPs. You need to make decisions on many things, including but not limited to when to exercise, how many shares to exercise, whether to make the 83(b) election or wait until vesting, when to sell, how many shares to sell, and whether to accept an offer from the options exchange. I recommend you read your plan document thoroughly, bring any questions to your HR department, or even consult outside professionals if necessary to fully understand all the options you have and help you make informed financial decisions based on your specific situation and avoid any unintended consequences.

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