If you try and look up information to learn more about your incentive stock options, most of what you’ll find addresses what happens when you exercise your options — but doesn’t go much farther than that.
But what you may not know is how much AMT you will need to pay, how to strategize for this, and when the tax will be due. This uncertainty may lead you to wonder when exactly you should exercise, and if you do so, whether you should hold or sell.
Understanding the potential tax when you exercise your ISOs is an important factor to consider (and this article can help you determine the right move in your situation). But asking questions about taxes at exercise is not the only time you need to think about what you could owe.
You need to think about taxes when you sell your incentive stock options shares, too. There are several types of tax that may influence how many incentive stock option shares you sell, when, and how much tax you pay on those shares.
These taxes include:
- The AMT credit
- Capital gains taxes
- The net investment income tax (NIIT)
- The AMT phase out tax.
If you understand the taxes and how to calculate them, you may be able to save thousands of dollars in tax with proper planning for the sale of your incentive stock options.
Here’s what to know and consider.
Incentive Stock Options and the AMT Credit
When your sell your previously exercised and held incentive stock options, you may receive an AMT credit.
An AMT credit occurs when your tentative minimum tax is lower than your regular tax. When you sell your ISO shares, you undo what caused you to pay AMT in the first place: the bargain element.
When you undo the bargain element, you “square up” tax with the IRS.
More specifically, selling ISOs shares is a negative adjustment to your tentative minimum taxable income. A negative adjustment may result in a greater spread between your tentative minimum tax and your regular tax, and that means a greater opportunity for an AMT credit.
A planning opportunity for the AMT credit arises if you have multiple lots of previously held ISOs. If you do, it may make sense to strategically sell a specific lot of stock options to accelerate your AMT credit.
Look at the bargain element paid when you exercised your ISOs. An exercise that had a larger bargain element when you exercised may have created a larger AMT than an exercise that had a smaller bargain element.
Given that, it makes sense that undoing the ISO exercise that caused the larger AMT might also create largest opportunity for an AMT credit.
The AMT credit gets a lot of attention on the sell-side of ISO shares because it can help drive down your tax bill in the year you sell your incentive stock options. But again, it’s not the only tax to consider.
Incentive Stock Options and Capital Gains Taxes
Capital gains tax is a tax paid on the gain when you sell certain types of property. This includes employee stock and stock options. The tax is levied on the profit you make only when you sell you stock, not during the period you hold the stock.
Assuming you sell your incentive stock options as a qualifying disposition, the realized gain from the grant price to the final sales price will be taxed as a long-term capital gain.
For 2018, long term capital gains are subject to either a 0%, 15%, or 20% tax rate depending on your adjusted gross income and your filing status. Specifically, the rates are as follows:
|Long-Term Capital Gains Tax Rate||Single||Married Filing Jointly|
|20%||$426,700 or more||$480,050 or more|
When planning to sell your ISO shares, it’s important to know these tax breakpoints. For example, let’s assume the following:
- You are 60 years old
- You file Married Filing Jointly
- You have no other income or deductions or previous tax credits
In this situation, you could sell enough shares to generate up to $77,400 of long-term capital gains and pay zero income tax. All of the profit from the sale would be in the 0% tax bracket.
If you exceeded $77,400 of capital gain, you’d be in the 15% income tax bracket. Every long-term capital gain dollar from $77,401 to $480,050 would get taxed at 15%, and long term capital gains over $480,050 would be taxed at 20%.
Once you know this information, you can use it for good tax planning when you sell your incentive stock options. Let’s assume it’s getting close to the end of the year and you have $500,000 of unrealized profit in your incentive stock options that meet the qualifying disposition standard.
Option 1 is to sell the shares all in 1 year. Option 2 is to spread the exercise over 2 years. Assuming you choose option 1 and capture $500,000 of long-term capital gain, here’s how you’d be taxed:
|Tax Rate||Year 1 LTCG||Year 1 Tax|
Option 2 might be the better answer here because you sell over 2 calendar years. Assuming your following calendar year tax return looks the same in terms of income and deductions, you could “defer” $77,400 of gain to the next year to “fill up” the income allowed to be taxed at 0% tax year 2 of the plan.
This removes your profit from the sale of ISO shares from being subjected to the 15% and 20% tax brackets and placing it into the 0% tax bracket instead.
Your taxes could look like this:
|Year 1 LTCG||Year 1 Tax||Year 2 LTCG||Year 2 Tax|
In Option 2, the total tax over the 2 years is $51,780 — almost $13,000 less than Option 1.
While the risk of holding stock for a longer period may or may not be worth the potential tax savings, a nearly 20% reduction in the tax you pay may be something to consider.
As always, individual tax scenarios are specific and should be tested accordingly. But this example highlights the valuable planning opportunities around the capital gains tax.
Incentive Stock Options and the Net Investment Income Tax (NIIT)
The NIIT is an additional tax that is levied on investment income if your income exceeds certain breakpoints. The tax is 3.8% on investment income in excess of $250,000 (if you file Married Filing Jointly) and $200,000 (if you file single).
If you follow the capital gains rules above, you will see there are two breakpoints that may impact your tax and financial planning: an adjusted gross income of $77,400, and again for an AGI of $480,050 (assuming you file as Married Filing Jointly).
The NIIT adds yet another breakpoint at $250,000. If you sell ISO shares and realize capital gains that exceed $250,000, you’d increase your total tax on profit from the sale of ISOs from 15% to 18.8%.
Continuing our example from above, we could assume you want to exercise enough shares to generate just enough gain to reach the 15% long-term capital gains rates. If you’re not aware of the NIIT, you might assume you’d pay 15% tax on the profit between $77,400 and $480,050.
Specifically, this is equal to:
($480,050 – $77,400) x 15%
However, because of the NIIT, the actual amount of tax you pay will be higher. In addition to the tax above, you will also pay NIIT on the profit in excess of $250,000:
(Long-Term Capital Gain – Threshold Amount) x NIIT Rate
($480,050 – $250,000) x 3.8%
If you add these two together, your total tax bill comes to $69,140. While the tax saving of 3.8% if you spread the sale over multiple years may be small, it still is worth paying attention to.
In addition, if you sold your ISO shares and that caused your income to exceed the 20% breakpoint of $480,050, you’d actually owe 20% + 3.8%, or 23.8%, in total taxes.
Incentive Stock Options and the AMT “Phase Out Tax”
The AMT uses a second set of tax calculations that include the bargain element, limiting deductions, and different tax rates (26% and 28%) to determine if you owe income tax.
The rules for AMT also have an exemption amount and phaseout that are different from the regular tax calculation. For calculation the AMT, the exemption and phase out period is as follows:
|2018 Exemption||2018 Phase Out (AMTI)|
|Married File Joint||$109,400||$1,000,000|
When your alternative minimum taxable income (AMTI) exceeds $1,000,000, you begin to lose your exemption at a rate of $0.25 per $1.00.
Let’s assume that you file as Married Filing Jointly and you have an AMTI of $1,250,000. Since your AMTI exceeds $1,000,000, you need to reduce your exemption by 25 cents on the dollar.
Said another way, for each $4 of income you need to reduce the exemption by $1. To calculate, we can do the following:
(1,250,000 – $1,000,000) / 4
If your exemption is $109,400 and you reduce it by $62,500, your exemption is limited to $46,900.
The net result of a lower exemption is a higher AMTI. A higher AMTI means that more of your money will be subject to tax, leading to a greater amount of tax due.
If your entire AMTI is taxed at 28%, we can take the example above to illustrate the tax impact by comparing a scenario with a full exemption vs. a scenario with a reduced exemption:
|If Full Exemption||Reduced Exemption|
|Married File Joint||$109,400||$46,900|
In the reduced exemption scenario, you are subject to $17,500 more tax due to the fact you exceeded the phaseout over $1,000,000 by $250,000. In other words, you paid an additional 7% “phase out tax” ($250,000 / $17,500).
When your AMIT reaches $1,437,600, your phase out reaches $0. At this point, there is no additional “phase out tax” on income that exceeds this amount.
What Does This Mean for You When Selling ISO Shares?
When your sell your incentive stock options shares in a qualifying disposition, you should pay attention to AMT credits, long-term capital gains, the NIIT, and the phaseout tax.
By knowing when you reach breakpoints that require you pay more tax, you can plan up to and around them. Doing so could save you thousands of dollars on your tax bill.
Unfortunately, this planning is not easy to do. You need to have a solid understanding of both the calculation for the regular tax and the alternative minimum tax. You should also pay attention to different lots of ISO shares and how they may or may not accelerate your AMT tax credit.
You also need to do all this tax planning as you consider investment planning. As you make these decisions around taxes, you can’t forget to think about investment risk, concentration risk, and your targeted financial goals that must be part of the overall plan.
If you find yourself overwhelmed by the process, it may make sense to work with someone who help answer all of these questions for you in a cohesive plan.
This material is intended for informational/educational purposes only and should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product. Hypothetical examples contained herein are for illustrative purposes only and do not reflect, nor attempt to predict, actual results of any investment. The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation. Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.