Getting stock options as part of your compensation is exciting \u2013 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\u2019re granted non-qualified stock options (NSOs) or incentive stock options (ISOs). It also depends on whether or not you exercise those options early.<\/p>\n\n\n\n
Here, we\u2019ll explain the basics of both NSOs and ISOs and take a look at what they could mean for your taxes. We\u2019ll also look at how early exercise and alternative minimum tax can come into play.<\/p>\n\n\n\n
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 \u201cexercising your options<\/a>.\u201d<\/p>\n\n\n\n The price you\u2019ll pay is what\u2019s known as the exercise price<\/a> and it\u2019s set when you\u2019re granted the stock. This price gets determined based on the stock\u2019s fair market value at the time it was granted to you \u2013 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). <\/p>\n\n\n\n You won\u2019t need to pay income tax on your NSOs when they\u2019re 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.<\/p>\n\n\n\n Let\u2019s 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\u2019ll imagine that the current fair market value of that stock when you exercise is $100. You\u2019ll owe taxes on the difference \u2013 in this case, $75 \u2013 when you exercise your NSOs. This difference is often referred to as the \u201cbargain element,\u201d and it gets reported on your paystub. It\u2019s 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). <\/p>\n\n\n\n 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 \u2013 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<\/a> tax if you earn more than $200,000 as a single filer or $250,000 as a joint married filer.<\/p>\n\n\n\n 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\u2019t owe taxes when you\u2019re granted ISOs.\u00a0<\/p>\n\n\n\n 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\u2019s good news for you!<\/p>\n\n\n\n How do you qualify for that lower tax rate on your ISOs? You\u2019ll need to do two things:<\/p>\n\n\n\n We\u2019ll illustrate this with another example. Let\u2019s say you work at a company that awards you ISOs which you exercise at an exercise price of $25 a year after they\u2019re granted to you. Exercising your ISOs is not a taxable event for regular tax purposes (though you could owe alternative minimum tax \u2013 more on that below). If you were to then sell the stock at a price of $100 a year after exercising your options, you\u2019d owe long-term capital gains taxes on the $75 of appreciation. If you don\u2019t meet the requirements above, the difference between the exercise price and the stock\u2019s fair market value (at exercise or sale, whichever is lower) gets taxed as ordinary income instead. This translates to a bigger tax bill.<\/p>\n\n\n\n First, the basics: alternative minimum tax<\/a>, 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 \u2013 AMT and the \u201cregular\u201d tax method. From there, you can determine which method yields the higher number, which is what you\u2019re required to pay. Whether or not you\u2019ll pay AMT is largely dependent on your income \u2013 in 2020, single filers earning under $72,900 and married joint filers earning under $113,400 won\u2019t pay AMT, but people earning more than that could.<\/p>\n\n\n\n You should know that AMT can come into play with ISOs. If you exercise your ISOs and don\u2019t 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\u2019s possible to get a pretty large tax bill even in a year when you didn\u2019t sell any stock. <\/p>\n\n\n\n Let\u2019s look at an example of how this works. Let\u2019s say you exercise your ISOs at an exercise price of $25 a year after it\u2019s granted to you, and you don\u2019t sell it that year. If the fair market value when you exercised was $100, the bargain element is $75, and it\u2019s 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\u2019d owe $2,100 in AMT.<\/p>\n\n\n\n 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\u2019t necessarily mean you\u2019re paying more in taxes \u2013 it just means you\u2019ll pay a chunk of them earlier. <\/p>\n\n\n\n There\u2019s a final consideration when it comes to employer-granted stock options: early exercise<\/a>, or exercising your options before they\u2019re 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\u2019s a risk inherent in early exercise: if your company fails, you\u2019re stuck with stock you can\u2019t sell \u2013 and you might have paid AMT for exercising, too.<\/p>\n\n\n\n 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\u2019s value will grow. (Otherwise, you should wait until your company begins the process to go public.)<\/p>\n\n\n\n Let\u2019s look at an example of what early exercise could mean for your taxes. Let\u2019s 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\u2019ll say you decided to early exercise those options at an exercise price of $25 on June 1, 2020 (a year early). Let\u2019s 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% \u2013 in which case you\u2019d owe $2,000 in taxes) instead of as ordinary income (up to 37% \u2013 in which case you\u2019d owe $3,700, or almost twice as much). <\/p>\n\n\n\nTaxes and NSOs<\/strong> <\/h3>\n\n\n\n
Incentive stock options<\/strong><\/h2>\n\n\n\n
The basics<\/strong> <\/h3>\n\n\n\n
Taxes and ISOs<\/strong><\/h3>\n\n\n\n
Alternative minimum tax<\/strong><\/h2>\n\n\n\n
Early exercise<\/strong><\/h2>\n\n\n\n