Incentive stock options are a powerful compensation tool that can help you grow your wealth. Companies award them to employees as a retention vehicle, to reward specific successes or as an incentive when trying to attract new employees.
There are several advantages to incentive stock options. Because they can provide you with a significant opportunity, it’s important to understand them more fully.
The Mechanics of an Incentive Stock Option
To begin with, it’s helpful to understand more about incentive stock options, including how they work and how you can take advantage of their potential. An incentive stock option is a stock option that gives you the right to purchase shares of stock at a predetermined price. Unlike other forms of stock options, such as non-qualified stock options, incentive stock options can only be given to company employees.
When you are awarded incentive stock options, the company will provide you with an option grant, a document that specifies the number of shares you’re eligible to purchase and what’s called the “vesting schedule,” which dictates the dates the options are available to be sold. The incentive stock option grant will also include a share price, called the “exercise” price, which is typically based on the stock price on the day the company grants your options. The exercise price determines how much you will pay for each incentive stock option. This price, multiplied by the number of granted options will tell you how much it will cost you to exercise all your options.
Let’s look at several advantages to incentive stock options.
Incentive Stock Options Have a Simple Process for Exercising
When you purchase shares through a stock option grant, the process is known as exercising your incentive stock options. Assuming the company stock price has risen since the time that you were awarded the stock option, you will have the potential benefit from that price appreciation. The process for exercising your incentive stock options is relatively straightforward, and you can exercise your options in one of several ways, depending on your short- and long-term financial goals.
Generally speaking, you can exercise your options once they have vested. Some plans, however, will offer an early exercise option that allows you to exercise before your shares are vested. If you do exercise your shares prior to the vesting, you are likely buying some that you cannot yet sell. The ability to sell the shares is subject to the vesting schedule.
When you exercise, you can typically do it in one of several ways. First, you can pay cash to purchase the shares. For example, let’s say you were granted 5000 options at an exercise price of $20 per share. One thousand shares have vested since you received your option grant. You could purchase those 1000 shares for $20,000 in cash. (1000 x $20 = $20,000.) By purchasing the shares upfront, you have the opportunity to hold them to take advantage of certain tax benefits, which we’ll discuss below regarding long-term capital gains. One risk associated with this approach is that your investment is subject to a possible downturn in the stock price. It may also reduce your ability to maintain a diversified portfolio by tying up your cash in the company’s stock.
Second, you can exercise your incentive stock options through what’s called a “cashless exercise” or “sell-to-cover” where you immediately sell some of your exercised shares, using the profits to pay for the option costs, and potential taxes, keeping the remainder, as discussed below.
The third approach is to exercise and sell all your shares immediately, commonly referred to as a same-day sale.
While the actual steps for exercising your incentive stock options are relatively simple, the method you choose depends on several factors, including when you need the income from the stock sale, possible tax strategies, and your confidence in the future growth of the company. A financial professional can advise you on a sound strategy and help you maximize your return based on your situation.
You Choose When to Exercise Your Incentive Stock Options
Once your incentive stock options have vested, you have the flexibility to choose when to exercise your stock options. Some of the factors you’ll want to consider include how much the shares have appreciated in value since they were awarded, the likelihood of the company continuing to prosper, and whether you need cash in the near term. All these factors can impact when you decide to exercise your options. Note that there are also many factors outside of the company’s control that can affect the stock price, both positively and negatively, so this should be taken into consideration when deciding when to exercise your options.
There are two definitions associated with exercising incentive stock options, depending on how long you hold your shares before selling them after exercising your options. If you sell the resulting shares less two years from the grant date and less than one year from the time of exercise, the sale will be considered a “disqualifying disposition.” The benefits of a disqualifying disposition may include reducing the risk of volatility of the company stock by selling the shares sooner and receiving the proceeds more quickly. If you hold the exercised shares for more than one year before selling, they will be considered a “qualifying disposition” allowing you to take advantage of the lower, long-term capital gains tax treatment, saving you money at tax time.
There is an important exception regarding the timing of exercising incentive stock options. In your company role, if you have advance knowledge of company earnings results or other significant business information, you may be deemed an “insider” and restricted to selling stock during a specific trading window. This window typically opens immediately following earnings announcements and closes by mid-quarter. If you’re deemed an insider, the company will likely notify you in advance to help protect you from any inadvertent wrongdoing. Within the confines of the trading window, you are free to exercise your vested options at your discretion.
Incentive Stock Options Offer the Potential to Participate in Stock Price Appreciation
Ordinarily, purchasing company stock on the open market requires you to use your funds to acquire the stock. If the stock appreciates, your money is working for you. If the stock price declines, your investment is worth less than when you started. Incentive stock options give you the potential to participate in the appreciation of a stock with no capital outlay or financial risk on your part.
As an example, let’s say you were granted 1000 shares of company stock through an incentive stock option, priced at $15. Over five years, the 1000 options fully vested, and the stock price increased to $50. If you exercised your options and immediately sold your shares, your profit from the options would be $35,000, minus appropriate taxes and fees. In this scenario, you would receive a $35,000 profit with zero initial financial investment.
Incentive Stock Option Grant Cost – 1,000 shares @ $15/share = $15,000
Current Share Value – 1,000 shares @$50/share = $50,000
Potential Profit – $50,000 – $15,000 = $35,000
If you had purchased the same 1000 shares for $15 with your cash and held them for five years, your capital outlay would have been $15,000, rather than zero. You would still earn the $35,000 in gains from the share appreciation, and you may benefit from long-term capital gains tax treatment. However, in this scenario, you would need to come up with the initial investment, which would have been subject to potential market volatility, and your funds would have been tied up for five years to accomplish the same profit.
Cost to Exercise and Hold – 1,000 shares @ $15/share = ($15,000)
Current Share Value – 1,000 shares @$50/share = $50,000
Potential Profit – $50,000 – $15,000 = $35,000
As you can see, incentive stock options can be a powerful way to participate in stock price appreciation without having to put your own money at risk.
Incentive Stock Options Are Not Subject to Payroll Taxes
Tax treatments are an important part of financial planning and a topic that requires careful consideration. One of the advantages of incentive stock options is the tax treatment they receive. As discussed, there are two approaches to exercising your options – qualifying and disqualifying dispositions. Qualifying dispositions are treated as long-term capital gains. Disqualifying dispositions are treated as ordinary income, with an important difference. There are no payroll taxes associated with the income from a disqualifying disposition, saving you a potentially significant amount of tax dollars.
Your earned income is not only subject to standard income tax, but also payroll taxes for Medicare and FICA. Medicare tax helps provide health insurance to retirees 65 and older, as well as some who are disabled. Medicare is taxed at a rate of 2.9% of your total wages, half of which are paid by your employer, and half of which (1.45%) you pay. Medicare taxes are applied to all earnings, regardless of your income level and an additional 0.9% tax for married couples filing jointly with incomes of $250,000 or higher or individuals earning $200,000 or more (in 2020).
FICA, the Federal Insurance Contributions Act, helps pay for Social Security. In 2020, the Social Security tax rate is 6.2%. The maximum Social Security tax employees and employers will each pay in 2020 is $8,537.40.
Because the profits or income from Incentive stock options are not subject to FICA or Medicare payroll taxes, you can keep a meaningful amount of the profits from your stock exercise.
Incentive Stock Options Can Qualify for Long-term Capital Gains
There are times when you need to be able to access the profits from an incentive stock option quickly, perhaps to cover the cost of a down payment on a home, college costs, or other needs. However, if you have the flexibility to exercise and hold your shares for more than one year before selling them, the sale is considered a qualifying disposition, as discussed above.
One of the key benefits of qualifying dispositions is the tax treatment they receive. Qualifying dispositions are treated as long-term capital gains, which can lower your tax burden on the profit you’ve realized from the sale. This is attractive because long-term capital gains are typically a lower tax rate than ordinary income or short-term capital gains rates. In addition, many other compensation programs, such as non-qualified stock options, are treated as ordinary income on your W-2, creating a potentially significant tax burden. Incentive stock options are a type stock option type that may allow you to take advantage of long-term capital gains tax rates, making them an attractive component of your overall compensation.
You May Get Alternative Minimum Tax Back as AMT Credit
When you exercise your incentive stock options, you may be subject to the alternative minimum tax.
In the given tax year, when you exercise your incentive stock options, the difference between the exercise price of the options and the fair market price at exercise is considered income that can trigger an AMT liability. Fortunately, you may be able to take advantage of the AMT credit for the year you sell your incentive stock option shares as a qualifying disposition. The AMT credit may help to reduce your tax liability.
Because of the complexity of these tax issues, it’s often valuable to review your financial situation with a professional who can help you get the most out of the current tax programs and limit your tax liabilities.
ISOs Allow You to Participate in the Success of the Company
Typically, if you’ve received incentive stock options, it is a recognition that you are a key contributor to your company’s success. As the company prospers, the stock price often will rise, and the value of your options will increase along with it.
It’s not uncommon when working for a larger organization for there to be a feeling of distance between an individual’s work and the overall success of the company. Incentive stock options help to create a feeling of ownership, pride, and proximity to the company’s success. This feeling of ownership in the company, and the prospect of increased income, often improves employee retention, morale, and employee satisfaction. Your efforts to help the company succeed are rewarded tangibly through the value of incentive stock options.
You Can Manage the Cash Flow Required to Cover the Cost of the Alternative Minimum Tax
As we discussed, exercising your incentive stock options may trigger an AMT liability, which can cause a cash flow shortage at tax time. A way to manage this issue is to focus on your cash flow by exercising your options and strategically holding the shares, selling them when cash is needed to pay the additional AMT costs. This approach is called AMT balancing.
AMT balancing may help insulate you from having to come up with a large amount of cash to pay your tax bill but also allows you to spread out the sale of your stock shares. There are a few reasons why this approach might be advantageous. For example, it can enable you to hold onto a portion of the shares beyond a 12-month window so that the profits on the shares will be treated as a qualifying disposition. This approach may allow you to manage the costs of the AMT liability while maximizing the long-term growth of the company’s stock.
As you can see, there are several important strategic decisions to make to maximize your incentive stock option profits. An investment professional can help you map out your strategy to take full advantage of this powerful compensation vehicle.
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.