Getting stock options as part of your compensation is exciting – it means you have an opportunity to own part of the company you work for. At the same time, you might not be sure what impact stock options will have on your taxes. That impact depends on whether you’re granted non-qualified stock options (NSOs) or incentive stock options (ISOs). It also depends on whether or not you exercise those options early.
Here, we’ll explain the basics of both NSOs and ISOs and take a look at what they could mean for your taxes. We’ll also look at how early exercise and alternative minimum tax can come into play.
Non-qualified stock options
The basics: If your employer grants you NSOs, that means you have the right to purchase shares of company stock for a certain price during a set period of time. Purchasing those shares is known as “exercising your options.”
The price you’ll pay is what’s known as the exercise price and it’s set when you’re granted the stock. This price gets determined based on the stock’s fair market value at the time it was granted to you – this is either the price of the stock on the open market (if the company is public) or the price according to a 409A appraisal (if the company is private).
Taxes and NSOs: You won’t need to pay income tax on your NSOs when they’re granted to you. But you will owe taxes on the difference between the exercise price and the current fair market value when you exercise your NSOs.
Let’s look at an example that illustrates how this works. Say you work at a company that awards you NSOs, and you exercise those options at an exercise price of $25. For the purposes of this example, we’ll imagine that the current fair market value of that stock when you exercise is $100. You’ll owe taxes on the difference – in this case, $75 – when you exercise your NSOs. This difference is often referred to as the “bargain element,” and it gets reported on your paystub. It’s subject to ordinary income tax rates and payroll taxes like Social Security and Medicare. The ordinary federal income tax rate for individuals ranges from 10% up to 37% (in addition to payroll taxes of up to 7.65% and a potential 0.9% Medicare surtax).
After you exercise your NSOs, if you hold the shares for at least a year, any gains or losses will be considered long-term capital gains or losses. This is a good thing – it means your gains going forward will be taxed at a lower rate. Tax rates for capital gains range from 0% to 20%. You could also potentially owe a 3.8% Net Investment Income tax if you earn more than $200,000 as a single filer or $250,000 as a joint married filer.
Incentive stock options
The basics: ISOs are similar to NSOs in several ways. Like NSOs, ISOs offer you the right to buy shares of stock for a certain price in a set period of time. And, like NSOs, you don’t owe taxes when you’re granted ISOs.
ISOs are different from NSOs, however, in that they offer you a tax incentive. If you meet certain requirements, any increase in value over the exercise price will get taxed as capital gains instead of ordinary income. That’s good news for you!
Taxes and ISOs: How do you qualify for that lower tax rate on your ISOs? You’ll need to do two things:
- Hold the shares for at least two years after they’re granted to you.
- Hold the shares for at least one year after you exercise them.
We’ll illustrate this with another example. Let’s say you work at a company that awards you ISOs which you exercise at an exercise price of $25 a year after they’re granted to you. Exercising your ISOs is not a taxable event for regular tax purposes (though you could owe alternative minimum tax – more on that below). If you were to then sell the stock at a price of $100 a year after exercising your options, you’d owe long-term capital gains taxes on the $75 of appreciation. If you don’t meet the requirements above, the difference between the exercise price and the stock’s fair market value (at exercise or sale, whichever is lower) gets taxed as ordinary income instead. This translates to a bigger tax bill.
Alternative minimum tax
First, the basics: alternative minimum tax, or AMT, is a separate tax system that exists to ensure that high earners pay at least a minimum level of taxes. Each year when you fill out your tax return, you need to calculate your taxes using two methods – AMT and the “regular” tax method. From there, you can determine which method yields the higher number, which is what you’re required to pay. Whether or not you’ll pay AMT is largely dependent on your income – in 2020, single filers earning under $72,900 and married joint filers earning under $113,400 won’t pay AMT, but people earning more than that could.
You should know that AMT can come into play with ISOs. If you exercise your ISOs and don’t sell them that year, the difference between the exercise price and the fair market value at the time when you exercised your ISOs (the bargain element) is still subject to AMT. As a result, it’s possible to get a pretty large tax bill even in a year when you didn’t sell any stock.
Let’s look at an example of how this works. Let’s say you exercise your ISOs at an exercise price of $25 a year after it’s granted to you, and you don’t sell it that year. If the fair market value when you exercised was $100, the bargain element is $75, and it’s subject to AMT. This translates to a tax rate of 26% to 28%. If you exercised 100 shares and were in the 28% bracket, you’d owe $2,100 in AMT.
That said, the AMT you pay when you exercise can be credited against the taxes you owe when you end up selling your stock down the road. If you sell those 100 shares described above at least a year later, you can credit the $2,100 you paid in AMT against the long-term capital gains taxes you owe as a result of the sale. In short, even if you pay AMT when you exercise your ISOs, it doesn’t necessarily mean you’re paying more in taxes – it just means you’ll pay a chunk of them earlier.
There’s a final consideration when it comes to employer-granted stock options: early exercise, or exercising your options before they’re fully vested. From a tax standpoint, the benefit of early exercise is that it starts the clock on qualifying for long-term capital gains treatment earlier. This helps you owe less in taxes when you eventually sell the stock. But there’s a risk inherent in early exercise: if your company fails, you’re stuck with stock you can’t sell – and you might have paid AMT for exercising, too.
In general, if your company offers early exercise, it only makes sense to do it if the exercise price of your shares is extremely low (which means your company is likely less than one year old) or you have a very high level of confidence that your company’s value will grow. (Otherwise, you should wait until your company begins the process to go public.)
Let’s look at an example of what early exercise could mean for your taxes. Let’s assume you work for an extremely promising company that grants you 100 ISOs that vest on June 1, 2021. For the purposes of this example, we’ll say you decided to early exercise those options at an exercise price of $25 on June 1, 2020 (a year early). Let’s assume that the stock then appreciates to a value of $125 per share, at which point you decide to sell all of it. If you were to sell the stock on June 2, 2022, you would be realizing $100 of gains on each share for a total gain of $10,000. Those gains would be taxed as long-term capital gains (a rate of up to 20% – in which case you’d owe $2,000 in taxes) instead of as ordinary income (up to 37% – in which case you’d owe $3,700, or almost twice as much).
An important reminder: if you exercise your options early, make sure you file an 83(b) election within 30 days. Essentially, this tells the IRS that you want to recognize the income associated with owning the stock immediately, even though it hasn’t vested yet. If you do this before your stock has appreciated beyond the strike price, you won’t owe any taxes when you early exercise. If you fail to do this when you early exercise ISOs, the difference between the exercise price and the fair market value on its vesting date is still subject to AMT. If you fail to do this when you early exercise NSOs, you’ll owe ordinary income tax on the difference.
Making the most of your options
Employer-granted stock options aren’t all taxed the same way. Because of that, it’s important to understand the basics of how they can impact your taxes. If you’re interested in learning even more about stock options and taxes, check out Wealthfront’s Guide to Equity & IPOs. You may also benefit from working with a tax advisor who can help you think through the details as part of a holistic overview of your situation and goals.
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About the author(s)
Or Pikary has been providing tax and financial planning solutions to his clients since 2012. Primarily serving closely held businesses and their owners, executives, and families, he helps his clients reduce their tax burden and retain more wealth. He can be reached at 310-481-1241 or firstname.lastname@example.org. Assurance, tax, and consulting offered through Moss Adams LLP. Investment advisory services offered through Moss Adams Wealth Advisors LLC. Investment banking offered through Moss Adams Capital LLC. View all posts by Or Pikary, CPA