By Sean Condon, CFP®
Stock options, which give you the right to buy a specific number of shares of company stock at a pre-set price, are becoming a popular way for companies to reward their employees. If you are fortunate enough to receive stock options as part of your compensation, there are important considerations to keep in mind. We have helped many employees navigate what to do with their stock options, and here are some of the things they have told us they wish they had known before they sold.
Know the Difference Between ISOs and NSOs
There are two main types of stock options: ISOs and NSOs. ISOs (incentive stock options) allow you to get preferential tax treatment as compared to NSOs (non-qualified stock options). This makes them the more valuable type of option if you understand the flexibility they offer.
There is no tax impact when you are granted ISOs or NSOs. Once your options become vested, you can exercise the option and purchase company stock; you need to do this before the expiration date when the options expire and become worthless.
The difference between the option’s exercise price and the value of the stock is the “bargain element.” This is your initial monetary gain, and for NSOs, you will be taxed on this amount at your ordinary income levels (as high as 40% depending on your income and where you live). With ISOs, you can have the same “bargain element” taxed at lower capital gains rates, currently as low as 15%. The determining factor is how long you hold the stock after exercising the option. If you exercise the option and immediately sell the stock, you have made a “disqualifying disposition” and the entire bargain element will be taxed at ordinary income levels. Conversely, if you hold the stock for more than a year, it can be a “qualifying disposition” and the entire gain will be taxed at the lower capital gains rates.
If you are confident in the prospects of the company stock and you have addressed diversification and stock-specific risk in your financial plan, it can be beneficial to exercise ISO options and “start the clock” on your holding period of the stock to eventually sell at the preferred capital gains tax rate after one year has passed.
Consider an 83(b) Election
An 83(b) election allows you to pay taxes on the fair market value of options when they are granted, as opposed to when you eventually exercise or sell. This is like the “starting the clock” example above because you are planning for future growth to be taxed at the lower capital gains rate.
Opting for an 83(b) election makes sense if you feel the value of the underlying stock will increase over time. Keep in mind, though, that prepaying your tax obligation could backfire if the stock falls after you pay taxes on the current value. You typically need to make an 83(b) election shortly after the shares are granted, so be sure to be aware of timing.
ISOs and the AMT
Before you take advantage of the preferred tax treatment of ISOs, you need to be ready to navigate the Alternative Minimum Tax (AMT). With ISOs, when properly planned for the AMT is essentially just a pre-payment of taxes that can get credited back. But it can add headaches, complications, and a need for cash flow when exercising large amounts of ISOs.
As discussed, when you exercise ISOs and continue to hold company stock, the bargain element is not taxed as ordinary income. It is, however, considered for the AMT, and likely taxed at a 26% or 28% rate. Ultimately, a “qualifying disposition” is still taxed at capital gains rate, not the AMT rate. So, if you hold the stock for a year or longer before selling, you are entitled to a credit between the AMT rate you paid in the year of exercise and the lower capital gains rate at the time of sale.
AMT projections and planning should be done with a tax advisor. AMT does not generally kick in until about $200K of income, so it often makes sense to annually exercise any ISOs you can under the AMT limit, to start the clock on the one-year holding period without having any AMT due. Separately, planning around the cash needed for AMT due in the year of exercise can have a big influence in helping you determine how many ISOs to exercise in a given year.
Understand Your Cash Flow Requirements
Exercising your options and selling can be a great liquidity event to take some cash out of your company to use toward other financial goals. However, there will likely be cash requirements you should plan when deciding how many options to exercise or sell.
When you exercise options, you need to pay the exercise price for the right to buy shares. This is a cost to consider that will lessen your liquidity. You may have an ability for a “cashless exercise” and use some of the stock value to pay the exercise cost. In addition to the exercise cost, you will likely trigger a sizeable tax due (either in ordinary income for NSOs or AMT for ISOs) which you need to plan for, as the bill does not come due until the following April. Getting $500K liquidity to spend on other investments or financial goals can be a problem if you have not set any aside for the next tax bill.
Diversification and Company-Specific Risk
Company stock options are an incredible way to build wealth as you participate in the success of your company. Yet as in all investment decisions, you need to consider how much of your portfolio you have tied up in a single company and the risk you are taking if it does not pan out.
Exercising and selling stock options is a way to diversify and de-risk your portfolio. This does not need to be an all-or-nothing decision. We often encourage employees to consider their future if they take just a portion of risk off the table. Will you still be able to meet your financial goals if you sell 25% of your company stock, for example? If yes, there may not be a need to take on the additional risk of holding. If the company stock soars, yes you will have lost out on some upside. But if the amount you still hold is life-changing anyway, that regret can be minimal. There is value in being able to sleep soundly at night knowing you have a plan. And in the worst case, if the stock ultimately fails, you have cashed out some investments that can still be working for you.
Unfortunately, you may choose to exercise a stock option only to see your shares fall in value. If that happens to you and you want to or need to sell those shares, you can “harvest” those losses by applying them against any capital gains you have, up to $3,000 a year. Using this “tax-loss harvesting” strategy can help reduce your overall tax liability.
Stock Options and Your Financial Plan
Decisions around selling stock options should be considered as part of your overall financial situation. We can help you analyze the options your company has granted you, and work with a tax specialist to help you make the best decision for your situation. To set up an exploratory meeting, call (844) 377-4963 or email firstname.lastname@example.org. You can also book an appointment online here.
Perritt Capital Management, Inc. is the Registered Investment Advisor for Windgate Wealth Management accounts and does not provide tax advice. Consult your professional tax advisor for questions concerning your personal tax or financial situation.
Data here is obtained from what are considered reliable sources; however, its accuracy, completeness, or reliability cannot be guaranteed.
First published February 2021.