Share prices go up and down all the time, so the longer you hold onto any amount of stock, the more you risk the share prices dropping. The hope is that when you decide to sell your shares, the fair market value of those shares has significantly increased. A strategic approach that considers factors like your cash flow, tax implications and overall portfolio diversification will give you the best chance of seeing the benefit of ISOs. Your advisor can help you develop a strategy for how and when you want to exercise your options.
Tax Benefits of Compensatory Stock Options | McNamee Hosea
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal.
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What are the ISO withholding rules?
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Non-Qualified Stock Options
What Are ISOs? Figure 1. The Net Investment Income Tax is an additional 3. This example does not account for any AMT owed. Tax Treatment of a Disqualifying Disposition If you fail to fulfill either of the waiting period requirements for a qualified disposition, then you have a disqualifying disposition and you lose the tax advantage of long-term capital gains rates.
Figure 2. The Net Investment Income Tax is added on top of their regular income rate. The biggest risk with ISOs is time—which also happens to be the greatest benefit. Bear with us. Topics Tax Strategies , Financial Planning. Related Posts. Tax Benefits of Homeownership. In tax lingo, your principal residence is the place where you legally reside. It's typically the place where you spend most of your time, but several other factors are also Financial Planning Tips for 'Nontraditional' Families. But if the current market price of the stock is below the price at which you can buy the share, you likely pass on your right to exercise the option and buy the shares.
If you find yourself with ISOs, it will be helpful to have a working knowledge of how this type of equity compensation is taxed. The first taxable event occurs when you exercise your ISOs. When you exercise your incentive stock options, you create a reportable tax event that is based on the spread between the grant price of the option and the fair market value of the stock when you exercise, multiplied by the number of shares you exercise.
This amount is known as the bargain element.
Stock Option Basics
The type of tax you may pay on the bargain element depends on what you do next. The Difference Between Qualifying vs. Disqualifying Disposition of Incentive Stock Options. Incentive stock options are often preferred to non-qualified stock options because you have the potential to pay long term capital gains rates on the bargain element of the stock should you meet specific holding requirements:. Should you meet these requirements, the bargain element and future gain gets taxed at preferential rates.
This is known as a qualifying disposition. In this scenario, you turned stock options into cash you can use for personal expenses or allocate to savings.
The rules of a disqualifying disposition state that the bargain element will be treated as ordinary income. Continuing the above example and assuming you exercise and then hold your ISOs , the tax implications become increasingly more complicated. You may be subject to the alternative minimum tax, or AMT, and long-term capital gains rates assuming you have a gain when you sell. AMT is the result of a secondary tax calculation that occurs every year when you file your tax return. As a taxpayer, you generally pay the higher of the regular tax calculation or the tentative minimum tax calculation.
The difference you pay if the tentative minimum tax is higher is the AMT. When you exercise and hold incentive stock options past the calendar year-end, no earned income is reported on your W2. But the bargain element is a tax preference item for calculating the tentative minimum tax. If your tentative minimum tax is higher than your regular tax, you may owe the higher of the two. A tentative minimum tax that is the higher of the two is often a direct result of the exercise and hold of ISOs. If you are following the above scenario, you may have noticed that you have in fact paid tax twice on a certain portion of the hypothetical example:.
Clearly, this would be a disadvantageous tax scenario. Enter the AMT credit. When you sell your incentive stock option shares in a final sale, you may be able to receive some of the AMT paid back as a credit. This is calculated on your tax return by looking at the difference between regular capital gains and AMT capital gains. This calculation may allow you to receive an AMT credit to cover the tax you already paid.
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Said another way, when you sell your shares, you may get some or all of the money you paid on AMT when you exercised and held back to you. This explains why much of the attention surrounding incentive stock options centers around AMT. A significant AMT bill may be a reason or not to exercise your shares. It should certainly be a reason to consider what your options strategy may be. In addition to AMT, you may want to think about long-term capital gains. When planning for your final sale of stock, it is important to understand what other income you have and how much room you have in various capital gains tax brackets.