Instead of intentionally exercising for a strategic reason, it’s possible to hold incentive stock options right up until the expiration date. At that point, people tend to exercise those options because they face a “use it or lose it” situation: if they don’t exercise, the option expires, and they’ll forfeit any potential value.
If you have incentive stock options but haven’t made a plan for them beyond “I’ll figure it out later,” you may want to consider the alternatives, and the alternatives are many.
One of the many strategies that you may consider is to exercise some or all of your incentive stock options early. How early depends on many factors, but earlier than a faced expiration date.
The Allure of Waiting
It’s understandable if you feel tempted to wait as long as possible to exercise your incentive stock options. When you do exercise, you create a taxable event.
The exact tax outcome depends on when you exercise your incentive stock options, if you hold some or all the shares beyond the exercise date, and you when you dispose of the shares in a final sale. But the bottom line is that you may very likely owe something.
The tax implications could include alternative minimum tax (AMT), ordinary income tax, and long-term capital gains tax. A pending tax bill and the uncertainty associated with tax may dissuade many people from taking action.
Waiting until your incentive stock options expire might also look like an attractive approach if you want certainty. If you exercise early, there is that “what if” question of, what if the value of your ISOs goes up? This encourages many people to wait until they simply can’t wait anymore because of an approaching expiration date.
Dealing with your options doesn’t need to be this way, where you wait until the last second and then face a high-pressure situation to act fast before the incentive stock options expire. Implementing a different strategy and exercising incentive stock options early might be a better option.
Let’s explore a few reasons to consider exercising early.
1 – Exercising Incentive Stock Options Early May Keep the Alternative Minimum Tax Low
Exercising incentive stock options may cause you to be subject to the alternative minimum tax (or AMT) in the year you exercise. The alternative minimum tax is a separate income tax calculation that often impacts a tax return if you exercise and hold incentive stock options. The greater the spread between the fair market value at exercise and the exercise price (known as the bargain element), the greater the potential for the alternative minimum tax.
Specifically, the bargain element is calculated as follows:
(Fair Market at Exercise – Exercise Price) * Options Exercised = Bargain Element
If we assume that the stock price will be higher in the future than it is now (which is certainly not guaranteed), we can also assume that the bargain element will be higher later than it will be now. It’s also fair to assume that the bargain element will be smaller now than it is later.
By having a smaller bargain element, you’ll likely lower the amount of alternative minimum tax you may owe (or, put another way, the impact you do see from alternative minimum tax will be lower than if you had a more substantial bargain element, all else being equal). If your goal is to keep the bargain element small and hopefully minimize AMT, it may make sense to exercise your incentive stock options early.
Do be aware that by exercising incentive stock options sooner rather than later, you not only buy the shares of stock via the option and possibly owe AMT, but you also hold company stock outright. A single stock is subject to normal market fluctuations, including the risk/reward tradeoff associated with stock positions.
In a worst-case scenario, you pay for shares, and you owe the alternative minimum tax due on the exercise. If the value of the stock then goes to zero, you lose all you originally invested in buying the shares at exercise. (This original investment would have been equal to the exercise price multiplied the number of shares exercised.)
You can compare this to a scenario in which the value of the stock goes to zero, but you never exercised. Your incentive stock options would simply expire as worthless, and you would not have lost anything. This doesn’t mean you shouldn’t consider an early exercise, but it’s important to consider a worst-case outcome before you do.
The decision to exercise early (when the spread is small) may still be wise for someone looking to minimize alternative minimum tax, expecting to hold the stock for the long term, and hoping the stock to appreciate in the future.
2 – Begin the Holding Period for Qualifying Disposition of Incentive Stock Options
To meet the standards for a qualifying disposition of incentive stock options, a disposition that would make the realized gain between the exercise price of the stock option and the final sale price eligible for preferential long-term capital gains treatment, the recipient of incentive stock options must meet two timelines.
- The final sale of the stock occurs at least two years after the grant date, AND
- The final sale of the stock occurs at least one year after the option was exercised.
By exercising your incentive stock options sooner rather than later, you begin the timeline on the second standard sooner. This means that you can sell your shares in a final exercise earlier, while still obtaining a qualifying disposition than you could have if you waited to exercise your options.
If a qualifying disposition is a goal, you might want to consider starting an exercise sooner rather than later, as you will need to wait at least one year past that exercise date to sell them. Your timeline may not work out in favor of a qualifying disposition if you wait and don’t exercise.
For example, let’s assume that you have the following incentive stock options:
- Exercise Price: $20
- Current Market Price: $100
- Price 1 Year Ago: $60
- Number of Incentive stock options: 1,000
You can liquidate your shares now by exercising and selling — but this won’t meet the standard for a qualifying disposition because you did not wait until at least one year after the exercise to sell. As a disqualifying disposition, profits will be taxed as ordinary income. In this example, that would be equal to $80,000.
(Current Market Price – Exercise Price) * Amount of Shares
(100 – 20) * 1000 = $80,000
That means, assuming a 32% tax bracket, you’ll owe $25,600 in taxes.
If you planned ahead and recognized your desire to liquidate the incentive stock options in one year, you could have initiated the process with an early exercise. You would have exercised at least one year prior to today, held the shares, and subsequently liquidated them for $100 per year.
Here’s a breakdown of how that strategy would work:
- 1 Year Prior – Exercise 1,000 options at $60 per share
- Claim the bargain element on the tax return. Bargain element equal to (Market Price at Exercise – Exercise price) * Amount of Shares
- Pay AMT as required
- At Least 1 Year Later – Sell the shares
- Assuming the final sale will be a qualifying disposition, which means you can claim long-term capital gains attributed to (Final Sale Price – Exercise Price) * Amount of Shares
- Receive (possibly) tax credit for alternative minimum paid upon the original exercise
Meeting the rules for a qualifying disposition will mean the $80,000 gain will be taxed as long-term capital gains. Assuming a 15% long-term capital gains rate, you’ll owe $12,000 in taxes ($80,000 * 15%).
That’s about half the amount you would have had to pay if you didn’t plan ahead, exercise early, and strategize for a qualifying disposition.
3 – Treat Incentive Stock Options as Compensation and Seek to Diversify*
It’s not uncommon to treat incentive stock options as cash compensation, as if it were part of your regular paycheck. When treating stock incentive stock options as cash compensation, the primary goal may be to exercise and sell the options as soon as possible, capturing any embedded value as soon as possible.
Upon liquidation, the proceeds of the sale can be diversified into other investment and asset allocation strategies. This process minimizes (or eliminates) the concentration risk associated with owning your employer’s stock.
Applying this strategy, incentive stock options are exercised and sold as soon as they vest. There is no consideration for meeting the standard for a qualifying disposition. The only standard is the standard that says sell and diversify, by reinvesting the profits back into a diversified investment portfolio.
The Best Incentive Stock Option Strategy
There is no one best incentive stock options strategy. A good strategy is one that suits your personal needs and fits into your plan. It’s also one that is planned out to maximize your after-tax income and meets both your short-term and long-term goals.
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.