Both NQSOs and ISOs may be subject to a vesting schedule during which you can buy a certain number of shares each year over a period of several years. Exercising your non-qualified stock options triggers a tax. It is then subject to all normal income taxes, plus Medicare and Social Security taxes. Any profit counts as a capital gain.

Stocks sold within a year are subject to income tax.

If you wait at least a year, they are subject to the lower long-term capital gains rate. Incentive stock options, on the other hand, are much more tax-friendly for employees.

Learn About Incentive Stock Options and the Taxes

You will still have to pay tax on the money you make from selling the actual stock units though. The long-term capital gains tax applies to sales made two years after the grant and one year after exercising the option. In this way, NSOs can be distributed as a sort of payment for services rendered or as an employee bonus.

Gains from NSOs are taxed at ordinary income rates. ISOs are only available to employees of a company and, as long as they are had for at least one year, are eligible for more favorable taxable gains rates, rather than income tax rates. This glossary of terms can help you gain a better understanding of your options no pun intended. Typically, a company will grant you stock options, which simply means they are giving you the opportunity to purchase company shares at a specific price during a specific window of time.

These options may also come with a vesting period, or waiting period, before you can purchase the full amount of optioned shares. As your shares vest, or once the vesting period is over, you have the opportunity to purchase the shares at the exercise price.

Language selection

Ideally, you will wait to exercise your option at a point where the market price of the stock exceeds the exercise price. You don't want to wait too long , however, as stock options have an expiration date, after which they can no longer be exercised. With NSOs, you get the opportunity to buy stock at a fixed price that is lower than market value. This provides instant growth in your investment. Since NSOs are not tax-advantaged, however, it is important to consider the tax ramifications of utilizing them. There are a few nuances to how NSOs are taxed. The first taxable event comes when you exercise your options to purchase shares.

How Stock Options Are Taxed & Reported

You are not immediately taxed on the grant date or when your option is fully vested. Once you exercise your stock option by purchasing stock, the difference between the fair market price of the stock and the exercise price will be taxed as ordinary income. While it might be tempting to exercise your options as soon as you can or when you think the market price is at a peak, there are other things to consider.

If possible, it can be smart to exercise options in years when your income is lower to minimize how much you'll owe in income tax when you buy those shares. In some cases, waiting until the expiration date to exercise your options can be the best course of action, especially if your goal is to immediately sell your shares for a large capital gain.

This is the best way to see an immediate return on your investment. Capital gains are the profits you get from selling your stock. Long-term capital gains come from selling stock held for one year or more, while short-term capital gains come from selling stock held for less than a year. Long-term capital gains rates can minimize the amount of tax you pay, meaning you end up with a greater net capital gain and more money in your pocket.

You can definitely spread them out over time. In fact, doing so has its advantages. If we continue with the above example, rather than purchasing all shares at once, you can spread those purchases out and exercise shares a year for five years—assuming the expiration date is more than five years away. You might exercise your options and expect the price of your shares to go up, but they could go down. You might end up leaving money on the table by waiting to sell or selling too early, or you could even lose money.

Investing is far from an exact science, and there are a number of factors that go into how and when you should exercise your NSOs. Working with a financial advisor will help you determine the right approach for you and ensure that you aren't needlessly losing your investment—to taxes or otherwise. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor. He is well versed in all areas of wealth management but specializes in taxation and real estate.

Tim shares his expertise through coaching team members, speaking engagements and client activities. He enjoys helping others and the community through his involvement with the Volunteer Income Tax Assistance program and the Financial Planning Association. Read More.

How to Report Stock Options on Your Tax Return

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