Money Girl explains different types of employee stock benefits and how they’re taxed.
You’ve probably heard about top employees at big companies who get paid stock options. No matter if you’re already one of them, or aspire to be one someday, you should know how these benefits work.
In this episode we’ll cover 2 types of employee stock benefits you might receive, in addition to a salary and other benefits. You’ll find out how stock benefits help you grow rich—plus, the huge difference in how they’re taxed.
What Is an Employee Stock Option (ESO)?
An employee stock option or ESO is a benefit given to certain employees of a company. Stock options give you the right to buy shares of the company stock at a predetermined price. It’s called an option because you’re never obligated to buy in—it’s always your choice.
Benefits of Employee Stock Options
You might wonder why an employer would want to pay you with stock options, instead of simply increasing your salary or giving you a cash bonus. Well, shareholders always want the value of their stock to rise.
So, tying some or all of your compensation to the company’s stock price gives you an incentive to do an outstanding job, increase profits, and help the stock appreciate. This aligns shareholder and employee goals and makes everyone happy, in theory.
Employee Stock Option Example
Here’s an example of how a typical stock option benefit might work: Let’s say Cindy starts a new job with Acme, Inc. and is given 10,000 stock options as part of her compensation package. She has to wait a set amount of time, known as a vesting period, before she can exercise part or all of the option.
A typical vesting schedule might require her to wait a total of 3 years. For instance, Cindy might have the right to buy 2,000 shares after one year of service, 4,000 shares after working for 2 years, and the remaining 4,000 shares after 3 years.
I mentioned that options come with a predetermined price. So, let’s do the math if Cindy’s option price is $10 a share. After one year on the job, Cindy can exercise her right to buy as many as 2,000 shares at $10 each, for a total purchase price of $20,000.
Cindy’s been watching Acme’s stock price creep up to $15 a share. So, she decides to buy shares at $10 each. Then she turns around and sells those shares for a profit of $5 each. That could potentially give Cindy a total gain of $10,000 ($5 x 2,000 shares)—not bad!
But the downside of stock options is that Acme’s stock price could take a dive down to $8 a share and never climb above Cindy’s option price of $10. In that case, she’d never exercise her option because there’d be nothing to gain from buying stock at a price above its trading value. You make money by buying low and selling high. That means Cindy would miss the opportunity to receive a bonus, even if she’s been working hard.