To exercise or not to exercise. It’s a loaded question, but it’s a hell of a lot easier to understand than Shakespeare.
When should I exercise my stock options?
There are 2 types of stock options
Your first thought may be to exercise all your options before the IPO. But before you make like Usain Bolt and sprint to your company-sponsored brokerage account, take a moment to understand the differences between the types of options and their tax rules.
Incentive stock options
ISOs will become your favorite income child because they’re usually taxed at your long-term capital gains rate (as long as you hold for at least one year after exercising and two years after your grant date). Just be sure to tell the NSOs (coming next) you receive that they’re loved in their own special way.
Note that ISOs are limited to $100,000 compensation per year and can only be issued to company employees. ISOs, for most people, do not cause a taxable event when they are exercised; be aware that there is a slight chance you’d be subject to AMT tax at the end of the year in certain situations.
Nonstatutory stock options
NSOs are second-best, but they have their perks:
- NSOs can be awarded to anyone and aren’t restricted to employees.
- NSOs come with more flexibility and is the more common form of stock compensation.
For example, you can hold NSOs for up to 10 years without expiring, and there’s no limit on how many you can receive in a year.
Imagine if you were paid NSOs from a particular social media company that went public back in 2012, and you didn’t sell until this year! Ultimate diamond hands move, bro …
When should you consider exercising your stock options?
Maybe you weren’t that lucky employee in the previous paragraph, but should you exercise options early, and how can you maximize your stock compensation? Consider these scenarios.
You’re considering changing jobs
Whether it’s ISOs or NSOs, the moment you quit your job, your stock options are on the clock for expiration. The standard practice with most companies is 90 days after leaving the company.
Once day 90 hits, this alternative form of compensation is gone quicker than LeBron leaving Cleveland after a championship. Also, your vesting schedule plays a crucial role in how many options can be exercised. Make investing your stock options no. 1 on your list to complete when you switch workplaces.
Your options are “in the money”
The most significant risk factor with stock option compensation is the company’s value exceeding your grant strike price.
Publicly traded or private, your company is hopefully moving up and to the right. Being an employee and knowing the company’s current trajectory is your most significant advantage in deciding if selling while you have a decent gain is the right move.
Other factors at play with your “in the money” options are:
- Your vesting schedule.
- The taxable income you’ve already earned this year. The last thing you want to do is sell your highly valued options to be taxed at the highest end of your tax bracket.
Patience is your expertise
In the modern days of information overload, it feels like we’ve lived five lifetimes in a matter of months. However, if you’ve recently celebrated the first anniversary with your ISO or NSO options, the tax savings could buy you dinner at Ruth’s Chris.
Like holding investments for more than a year and a day in a brokerage account to enjoy long-term capital gains rates, the same goes for options. The difference is selling options one year + one day from the exercise date drops your taxable gain from ordinary income tax to long-term capital gains tax. Depending on your financial situation, that reduction in tax rates could mean thousands in savings … aka a trip to Cabo this summer.
What happens when you exercise an option?
With ISOs, there are no taxes due (though AMT could apply).
NSOs are taxable in the year you exercise: The spread between your exercise price and the stock’s FMV is subject to ordinary income tax rates.
Waiting over a year to sell your exercised ISO or NSO options will put your earnings in the long-term capital gains bucket, which means biiiig tax savings.
Manage your options like a C-suite pro
Income is fun, particularly when it can increase in value instead of just being deposited into your bank account. Remember that you have options with your options (best pun you’ll read this week).
