Nonqualified stock options

These are the stock options of choice for broad-based plans. Generally, you owe no tax when these options are granted. Rather, you are required to pay ordinary income tax on the difference, or "spread," between the grant price and the stock's market value when you purchase ("exercise") the shares. Companies get to deduct this spread as a compensation expense.

After that, any subsequent appreciation in the stock is taxed at capital gains rates when you sell. Keep the stock for more than a year and you'll have a long-term capital gain, taxed at a top rate of 20%; hold for one year or less and your gain is short-term, taxed at higher, ordinary income tax rates. Nonqualified options can be granted at a discount to the stock's then market value. They also are "transferable" to children and charity, provided your company permits it.

Incentive stock options (ISOs)

These are also known as "qualified" stock options because they qualify to receive special tax treatment. No income tax is due at grant or exercise. Rather, the tax is deferred until you sell the stock. At that point, the entire option gain (the initial spread at exercise plus any subsequent appreciation) is taxed at long-term capital gains rates, provided you sell at least two years after the option is granted and at least one year after you exercise.

ISOs give employers no tax advantages and, so, generally are reserved as perks for the top brass, who tend to benefit more from ISO's capital gains tax treatment than workers in lower income tax brackets. High-paid workers also are more likely than low-paid workers to have cash to buy the shares at exercise and ride out the lengthy holding period between exercise and sale.

If you don't meet the holding period requirements, the sale is a "disqualifying disposition" and you are taxed as if you had held nonqualified options. The spread at exercise is taxed as ordinary income, and only the subsequent appreciation is taxed as capital gain.

Unlike nonqualified options, ISOs may not be granted at a discount to the stock's then market value, and they are not transferable, other than by will.

Two warnings apply here: 1. No more than $100,000 in ISOs can become exercisable in any year. 2. The spread at exercise is considered a preference item for purposes of calculating the dreaded Alternative Minimum Tax (AMT), increasing taxable income for AMT purposes. A disqualifying disposition can help you avoid this tax.

Next: Exercising options