By Jason Epps, CFP®, CRPC®
If you’re an employee, taking time to understand your benefits package is crucial for making informed decisions about your compensation—and financial future. In addition to health insurance and retirement plans, stock options play a valuable role in your overall compensation by providing the chance to purchase company shares while benefiting from its potential growth.
However, it’s important to note that stock options can significantly influence your tax liability, adding a layer of complexity to their understanding. In this blog post, we explore four key aspects of stock options and how they may impact your tax situation. We hope this information guides you toward educated choices regarding your employee benefits so you can pursue your financial future with clarity and confidence.
Stock Options: NSOs and ISOs
Before we look ahead at the tax implications, it’s crucial to recognize the distinction between non-qualified stock options (NSOs) and incentive stock options (ISOs). This is because the tax treatment for each type differs significantly.
An NSO is a type of stock benefit that, when used, is generally considered ordinary income. On the other hand, an ISO is a type of stock benefit that may qualify for favorable tax treatment if specific conditions are met, which we discuss below.
Stock Options Don’t Create a Tax Liability Until Exercised
One of the key advantages of stock options is that they do not create a tax liability until they are exercised. This means you won’t owe any taxes when you receive the options and can defer paying taxes on the options until they decide to exercise them. This deferral can be helpful if you don’t need the money and want to hold on to your options for a longer period of time, potentially allowing the stock price to increase before they exercise. Of course, you will eventually have to pay taxes on your options, but that won’t happen until you exercise them.
How Options Are Taxed When Exercised
When you exercise your stock options, you will need to pay taxes on the difference between the market price at the time of exercise and the exercise price. This difference is known as the “spread” and is treated differently depending on what type of stock option you have.
For NSOs, this spread is treated as ordinary income and is subject to your marginal tax rate for that year. It’s necessary to understand that the amount of taxes owed on the spread can vary widely depending on your income level, the exercise price, and the current market price of the stock.
ISOs aren’t subject to regular tax at exercise but may be subject to alternative minimum tax (AMT). When you exercise an ISO, the spread is counted as income in an AMT calculation. This could mean you have to pay additional taxes when you file your return. However, when you eventually sell the stock gained at exercise, the profit may potentially be taxed at the lower capital gains rate, not as regular income. To qualify for this more favorable tax treatment, ISOs must be held for more than one year after exercising and for two years from the date they were granted.
If you have a significant amount of stock options and you exercise them all at once, those options could push you into a higher tax bracket, resulting in a much higher overall tax bill—even with the favorable treatment of ISOs. That makes it all the more important to properly plan ahead for when you want to exercise and how you’ll pay the tax liability.
Plan Ahead for the Tax Liability
When it comes to exercising your stock options, it’s crucial to plan ahead for the tax liability that will result from the transaction. As discussed above, it may not make sense to exercise all your options in one calendar year. It may be a better option to use a multi-year strategy, where you only exercise a certain portion every year until you are finished with the options.
Another consideration is will your income, or your family’s income, change in the future? If so, it’s worth considering waiting until your income is lower to exercise these options. On the other hand, if you plan to have a higher income in the future, it’ll be worth considering these options sooner rather than later.
While we can’t create the perfect strategy for you in this blog post, we can say it’s vital to think through these different strategies so you can pick the right one.
You Might Be Able to Use Shares to Pay the Taxes
If you’re worried about having enough cash on hand to cover the tax liability resulting from exercising your stock options, there’s good news: some companies allow you to use your shares to pay the taxes owed. This strategy involves having a portion of the shares withheld to cover the tax bill. The remaining shares are then yours, allowing you to hold on to the stock or sell it as desired.
While this can be a convenient way to manage your tax liability without having to come up with the funds to pay the tax bill separately, it’s important to note that this strategy will result in less shares in your name, which could impact your potential for future gains. It’s critical to weigh the pros and cons of net exercise and consider your long-term financial goals when deciding whether to use shares to pay the taxes owed. Overall, understanding the different strategies available for managing your tax liability can help you make informed decisions about your stock options and maximize your employee benefits.
Create a Custom Tax Strategy
As you come to understand the complexities of stock options, it’s important to consider how your decisions align with your overarching financial objectives. Take the time to assess how these options can help you realize your long-term goals while being mindful of their tax implications.
At KFA Private Wealth Group, we understand the ins and outs of stock options and make it a priority to educate our clients on which choices best fit their specific circumstances. Reach out today to schedule a complimentary, no-obligation phone call, and let us guide you through the nuances of your financial journey. Email jepps@kfapwg.com or call 571-386-2022.
About Jason
Jason Epps is vice president and private wealth advisor at KFA Private Wealth Group, a registered independent advisory firm founded on the premise of providing conflict-free financial and investment advice. With over 17 years of experience, Jason possesses the unique knowledge and expertise necessary to provide his clients with the financial guidance to help them find confidence in their financial future. Jason is a CERTIFIED FINANCIAL PLANNER™ practitioner and a Chartered Retirement Planning Counselor℠, CRPC®, and believes that a financial plan is only as strong as the advisor’s understanding of the core values and beliefs of each client. He serves a diverse range of clients, from young accumulators to pre-retirees and retirees, including business owners and professionals in a variety of fields. Jason graduated cum laude from Mount St. Mary’s University, where he currently serves on the university’s Board of Trustees. While at Mount St. Mary’s, Jason played four years of Division I college basketball. In his spare time, he enjoys traveling, trying new restaurants, and cheering on the local D.C. sports teams. To learn more about Jason, connect with him on LinkedIn.