Some employees earn stock options as part of their compensation packages at work, giving them the right to purchase shares of stock at a fixed price in the future. If the stock gains in value over time, employees can exercise their stock options, sell the shares, and receive a gain.
Yet there are big implications for your taxes from exercising employee stock options, and it's important to understand all the intricacies involved. In particular, once you know which type of options you have, you can calculate your best strategy for exercising those options and reaping the rewards of your successful work.
Employees can receive one of two types of stock options. Incentive stock options, or ISOs for short, are available only to employees of a company. Nonqualified stock options, or NQSOs, can be given to anyone, including outside consultants and corporate board directors, as well as workers.
With incentive stock options, exercising the option doesn't create a taxable event for ordinary income tax purposes as long as you hold onto the shares that you receive upon exercise. Later on, you'll pay capital gains tax on any gain when you sell, but as long as you hold the shares for longer than a year after exercising the option, the gain will be eligible for lower long-term capital gains rates.
By contrast, NQSOs create two separate taxable events. First, when you exercise the option, you'll be treated as having received taxable compensation equal to the difference between the current market value of the shares you receive and the amount that you have to pay under the option contract. Later, when you sell the shares, any difference between the value of the shares when sold compared to the market value of the shares when you exercised the option is treated as a capital gain or loss.
A basic example shows how this works in practice. You then decide to sell. You can see from the example above that sometimes it can make more sense with NQSOs to exercise sooner rather than later. Any gain before exercise is subject to ordinary income tax, but gain after exercise gets taxed at potentially lower capital gains rates.
But the downside from early exercise is that you have to pay the exercise price right away, rather than keeping it invested elsewhere. That's where the calculator below can be helpful.
By running through various scenarios with NQSOs, you can decide whether exercising early makes more sense than simply waiting until closer to the expiration date of the options to exercise.
The following language is provided by CalcXML, which built the calculator below. As with any tool, it is only as accurate as the assumptions it makes and the data it has, and should not be relied on as a substitute for a financial advisor or a tax professional.
Finally, keep in mind that the tax issues with stock options can be extremely complex. For example, with incentive stock options, there are implications that involve the alternative minimum tax.
If you're subject to that tax, then ISOs can have tax impacts. Moreover, AMT treatment can have disastrous consequences if the stock goes through a cycle of big gains and subsequent declines in the share price. Receiving stock options is a great employee benefit, but it also requires you to be thoughtful about what to do with them. By using the resources at your disposal, you can make a better decision with your stock options, and maximize their value while keeping taxes as low as possible.
The Motley Fool has a disclosure policy. Dan Caplinger has been a contract writer for the Motley Fool since As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.
With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.
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